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Modern  Business 

\    SERIES    OF    TEXTS    PREPARED    AS 

PART   OF   THE   MODERN  BUSINESS 

COURSE  AND  SERVICE  OF  THE 

ALEXANDER  HAMILTON 

INSTITUTE 


ALEXANDER  HAMILTON  INSTITUTE 
NEW  YORK 


Modern  Business 

Editor-in-Chief 

JOSEPH  FRENCH  JOHNSON 

Dean,  New  York  University  School  of  Commerce,  Accounts  and  Finance 

Associate  Editors: 

LEE  GALLOWAY,  PETER  P,  WAHLSTAD 
ROLAND  P.  FALKNER 


Titles  Authors 

Business  and  the  Man Joseph  French  Johnson 

Economics  of  Business Frank  L.  McVey 

Organization  and  Control Charles W.Gersten berg 

Factory  and  Office  Administration      .      .  Lee  Galloway 

Marketing  Methods       •      .  - Ralph  Starr  Butler 

Advertising  Principles Herbert  F.  De  Bower 

Salesmanship  and  Sales  Management      .      .  John  G.  Jones 

Credit  and  the  Credit  Man Peter  P.  Wahlstad 

Accounting  Principles Thomas  W.  Mitchell 

Cost  Finding ,  Dexter  S.  Kimball 

Corporation  Finance William  H.  Walker 

Business  Correspondence Harrison  McJohnston 

Advertising  Campaigns Mac  Martin 

Railway  Traffic Edwin  J.  Clapp 

Foreign  Trade  and  Shipping Erich  W.  Zimmermann 

Banking Major  B.  Foster 

Domestic  and  Foreign  Exchange  .      .  .  E.  L.  Stewart  Patterson 

Insurance  and  Real  Estate IwT^t11-  ?ardy 

L Walter  Lindner 

Merchandising John  B.  Swinney 

The  Exchanges  and  Speculation  ....  Albert  W.  Atwood 

Accounting  Practice  and  Auditing  .  .  John  T.  Madden 

Financial  and  Business  Statements  .      .      .  Leo  Greendlinger 

Investment Edward  D.  Jones 

Business  and  the  Government      ....  Jeremiah  W.  Jenks 


FINANCIAL  AND  BUSINESS 
STATEMENTS 


BY 

LEO  GREENDLINGER,  M.C.S.,  C.P.A. 

Treasurer,  Alexander  Hamilton  Institute,  formerly  Assistant 

Professor   of   Accounting,   New    York    University 

School  of  Commerce,  Accounts  and  Finance 


MODERN  BUSINESS 

VOLUME   22 


ALEXANDER  HAMILTON  INSTITUTE 
NEW  YORK 


COPYRIGHT.  1917.  BY 

ALEXANDER  HAMILTON  INSTITUTE 


COPYRIGHT  EN  GREAT  BRITAIN.  1917.  BY 

ALEXANDER  HAMILTON  INSTITUTE 


The  title  and  con  tents  of  this  volume, 
as  well  as  the  business  growing  out  of 

i   by  lav  ■ 
lating  to  trade  marks  and  unfair  trade. 

All  r  |  including  transla- 

tion into  Scandinavian 


Repialrrea  trade  mo*r 

Mz-  -ado,  M.  i* 

...  bU  r.s.  a. 


PREFACE 

Twentv-iive  years  ago  it  was  not  so  important  as 
at  present  for  the  average  executive  to  be  familiar 
with  accounting  terminology,  or  to  know  how  to  read 
a  financial  statement. 

Such  terms  as  capital  and  revenue  expenditures, 
contingency  reserves,  qualified  certification,  and  the 
like  did  not  mean  much  to  him.  The  growth  oi'  mod- 
ern business  has  changed  all  this.  The  executive  of 
today  is  expected  to  have  a  broader  knowledge  oi' 
business  than  his  predecessor  of  twenty-five  years  ago. 

To  help  the  executive  to  read  a  financial  or  busi- 
ness statement  intelligently;  to  help  him  get  a  clearer 
insight  into  business  statistics:  to  help  him  to  under- 
stand how  to  interpret  professional  reports,  is  the  mis- 
sion oi'  this  book. 

The  author  has  avoided,  as  much  as  possible,  the 
use  o\'  highly  technical  terms.      lie  lias  attempted  to 

interpret  the  contents  o(  financial  and  business  state- 
ments rather  than  to  deal  with  the  construction  of 
such  statements,  as  that  feature  is  fully  covered  in 
the  volume  on  "Accounting  Practice  and   Auditing.  * 

Where  the  subject  matter  treated  is  of  a  contro- 
versial nature  the  author  has  endeavored  to  gi\e  the 

"pros"  and  "eons,"  always  leaving  to  the  reader  the 

v 


vi  PREFACE 

freedom  of  choice.  In  some  cases  the  reader  will  find 
that  one  phase  of  such  subject  matter  is  treated  in 
this  volume  while  the  other  phase  may,  be  treated  in 
another  volume.  Thus  the  question  as  to  whether  in- 
terest on  capital  is  a  proper  charge  to  cost  of  produc- 
tion is  treated  in  the  affirmative  in  "Cost  Finding," 
while  the  negative  side  is  treated  in  this  volume. 

As  the  corporate  form  of  management,  tho  not 
universal,  is  far  ahead  of  partnerships  and  individual 
proprietorships  in  popularity,  financial  budgets  are 
becoming  an  important  feature  of  modern  busi- 
ness. For  that  matter,  even  in  the  case  of  sole  pro- 
prietorships it  is  preferable  to  have  the  fiscal  financial 
plans  fully  developed  and  properly  arranged  in  bud- 
get form  than  to  grope  in  darkness.  So  far  as  the 
author  knows,  this  is  the  first  attempt  to  put  before 
American  readers  information  on  the  preparation  of 
private  financial  budgets.  To  help  the  reader  con- 
trast the  private  business  budget  with  municipal 
budgets,  the  writer  has  added  information  on  the 
latter. 

The  author  takes  this  opportunity  of  thanking  Mr. 
J.  T.  Madden,  C.P.A.,  (X.  Y.),  Professor  of  Ac- 
counting at  New  York  University,  Dr.  R.  P.  Falk- 
ner,  and  Mr.  F.  C.  Russell,  of  the  Alexander  Hamil- 
ton Institute,  for  their  valuable  aid  in  the  preparation 
of  this  volume. 

Leo  Greendlinger. 


TABLE  OF  CONTENTS 

CHAPTER  I 

IMPORTANCE  OF  CLASSIFIED  INFORMATION 

SECTION  PAQE 

1.  Present  Need  for  Classified  Information     ...  1 

2.  Classified  Information  Measures  Efficiency      .      .  2 

3.  Business  Policies 8 

4.  How  Outside  Factors  Affect  a  Business  Organiza- 

tion                   3 

5.  Financial  Statements  Classified 4 

6.  Statistical  Information 4 

7.  Departmental  Statements 5 

8.  Purpose  of  Financial  Statements 6 

9.  Prerequisites  of  the  Executive 6 

10.  Requisites  of  Proper  Financial  Statements       .      .  7 

11.  Financial  Statements  Should  Be  Comparative       .  7 

12.  Importance  of  the  Personal  -Element     ....  8 

13.  Consideration  of  Outside  Factors 9 

14.  Executive's    Reasons    for   a    Study    of   Financial 

Statements *" 

15.  Stockholders'  Reasons  for  a  Study  of  Financial 

Statements 10 

16.  Information  as  a  Guide  to  Legislation       ...  11 

CHAPTER  II 
STATISTICAL  AND  GRAPHICAL  STATEMENTS 

1.  Purpose  and  Scope  of  Business  Statistics  ...  13 

2.  Official  and  Business  Statistics 14 

3.  The  Contents  of  Business  Statistics     ....  15 

vii 


viii       FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

4.  Uses  of  Business  Statistics 16 

5.  How  Much  Information  Should  Department  Heads 

Be  Given? 16 

6.  Record  of  Orders  and  Sales 17 

7.  Inventory  and  Purchase  Records  Should  Be  Avail- 

able         18 

8.  Analytical  Expense  Statements 19 

9.  Departmental  Profit  and  Loss  Statements  ...  19 

10.  Results  Stated  in  Percentages 19 

11.  Form  of  Statistical  Statements 21 

12.  Statistical  Comparisons 22 

13.  Past  and  Present  Performances 22 

14.  Results,  Year  by  Year 22 

15.  Results,  Month  by  Month 23 

16.  Results,  Week  by  Week 23 

17.  Results,  Day  by  Day 24 

18.  Establishing  Standards  of  Comparison     ...  25 

19.  The  Percentage 26 

20.  The  Ratio      .      .      .     I 27 

21.  Graphic  Statements 28 

22.  The  Appeal  to  the  Eye 29 

23.  Curves 31 

24.  Need  of  Caution  in  Interpretation 34 

CHAPTER  III 
AUXILIARY  STATEMENTS 

1.  Schedule  of  Accounts  Receivable 36 

2.  Statements  of  New  Customers 37 

3.  Importance    from     Management     Standpoint     of 

Notes  Taken  from  Customers 38 

4.  Schedule  of  Inventory 38 

5.  Production  Reports 39 

6.  Sales  Analyses 39 


CONTENTS  ix 

SECTION1  PAGE 

7.  Expense  Schedules 40 

8.  Cash  Report 41 

9.  False  Statements 42 

10.  Intentional  Misrepresentation 43 

11.  Incorrect  Preparation 44 

12.  Preparation  of  Statements  for  Executives       .      .  45 

CHAPTER  IV 

ANALYSIS  AND  INTERPRETATION  OF  INCOME 
STATEMENTS 

1.  General  Division  of  the  Income  Statements       .      .  48 

2.  Gross  Sales  or  Gross  Income 49 

3.  Goods  on  Sale  or  Return 50 

4.  Trade  Discount  on  Sales 50 

5.  Price  Corrections 51 

6.  Sales  Returns 51 

7.  Prepaid  Charges  Treated  as  Sales 52 

8.  Sales  of  Scrap  or  Residuals 52 

9.  Percentage  Calculations 53 

10.  Outward  Freight  and  Cartage 55 

11.  Service  Liabilities 55 

12.  Instalment  Sales 56 

13.  Containers  Included  in  Sales  Prices       ....  56 

14.  Other  Items  of  Miscellaneous  Income    ....  57 

15.  Comparisons   of   Sales   with   the   Amount   of  the 

Final  Inventory 57 

16.  Distinction  Between  Cost  and  Expense       ...  59 

17.  Distinction  Between  Expenditures  and  Disburse- 

ments      59 

18.  Elements  of  Cost 60 

19.  Treatment  of  Cash  Discounts  on  Purchases     .      .  61 

20.  Labor 62 

21.  Heat,  Light  and  Power 63 


x         FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAOT 

22.  Cost  of  Manufacture  and  Cost  of  Sales  Distin- 

guished         64 

23.  Percentage  Calculations  Must  Be  Made  on  Correct 

Basis  65 

24*.     Calculation  of  the  Turnover 66 

CHAPTER  V 

ANALYSIS  AND  INTERPRETATION  OF  INCOME 
STATEMENTS  (Continued) 

1.  Quantity  Discounts  on  Purchases 69 

2.  Purchases  Returns  and  Allowances       ....  69 

3.  Maintenance  Charges 70 

4.  Selling  Expenses '70 

5.  Rebates  Allowed  to  Customers 71 

6.  Other  Selling  Expenses 72 

7.  Distribution  of  Stable  and  Delivery  Expense  .      .  72 

8.  Administrative  Expenses 73 

9.  Selling  Profit  and  Net  Profit  from  Operation  .       .  73 

10.  Effect  of  Gross  Earnings 74 

11.  Operating  Expense  Is  Not  Easy  to  Reduce     .       .  74 

12.  Interpretation  of  Net  Income 75 

13.  Other  Income  and  Income  Charge 76 

14.  Treatment  of  Taxes  and  Rent 77 

15.  Cash  Discounts  on  Sales 77 

16.  Insurance  Expense 78 

17.  Profit  and  Loss  Credits  and  Charges  ....  79 

18.  Transfer  of  Net  Profits 80 

19.  Deficits 80 

20.  Analysis  of  Surplus  Fluctuations 81 

CHAPTER  VI 

CONSOLIDATED  INCOME  STATEMENTS 

1.  Introduction 83 

2.  Distinction  Between  Parent  and  Holding  Compa- 

nies         83 


CONTENTS  xi 

SECTION  PAGE 

Ownership  of  the  Stock  of  a  Company  Does  Not 

Mean  Ownership  of  Its  Assets 85 

Increase   of  Value   Due  to   Economic   Conditions 

Not  to  Be  Recognized 86 

A  Balance  Sheet  Should  Disclose  Financial  Condi- 
tion        87 

The  Accountant  and  the  Law 87 

Accounting  Practice  and  the  Law  at  Variance       .      88 
Pertinent  Facts  Which  Should  Be  Shown  in  Finan- 
cial Statements 89 

9.     Statements  in  Form  of  Balance  Sheets  and  Income 

Accounts 89 

10.  Financial  Results  Stated  by  Means  of  Consolidated 

Statements 90 

11.  Consolidation  of  Statements 91 

12.  Factors  Not  Disclosed  Except  Thru  the  Medium 

of  Consolidated  Statements 92 

13.  Division  of  Profitable  Business 92 

14.  Dividends  Out  of  Capital  May  Remain  Undisclosed  93 

15.  Advances  to  Subsidiaries 94* 

16.  Failure  to  Provide  for  Operating  Losses  of  Subsid- 

iaries Not  Apparent 94* 

17.  Balance  Sheets  Should  Be  Consolidated     ...  95 

18.  Inter-company  Transactions 96 

19.  Inter-company  Profits  on  Construction      ...  98 

CHAPTER  VII 

VALUATION  AND  INTERPRETATION"  OF 
FIXED  ASSETS 

1.  Fixed  or  Capital  Assets 100 

2.  Real  Estate,  or  Real  Property 100 

3.  Plant  Land  Distinguished  from  Land  Held  as  an 

Investment 101 

4.  Valuation  of  Plant  Land 101 


xii       FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

5.  Land  Improvements 101 

6.  Land  Investment 102 

7.  The  Treatment  of  Land  as  Stock  in  Trade     .      .    102 

8.  The  Valuation  of  Leaseholds  and  Leasehold  Rights  104 

9.  Mineral  Land  and  Timber  Property    .       .      .      .105 

10.  Depreciation  or  Appreciation  of  Land       .       .      .    107 

11.  Important  Points  in  the  Valuation  of  Buildings 

and  Structures 107 

12.  Repairs,    Renewals,    Additions,    Betterments    and 

Replacements 110 

13.  Importance    of    Segregating    the    Investment    in 

Equipment 110 

14.  Machinery  and  Fixed  Tools Ill 

15.  The  Valuation  of  Furniture  and  Fixtures  .       .       .  112 

16.  The  Principles  Employed  in  the  Valuation  of  Sta- 

ble and  Garage  Equipment 113 

17.  Patterns,  Drawings,  and  Dies 113 

18.  The  General  Problem  of  Depreciation  ....    113 

19.  Special  Factors  to  Be  Considered  in  Interpreting 

a  Balance  Sheet 114 

20.  Equipment    Purchased    on    the    Partial-payment 

Plan 116 

CHAPTER  VIII 

VALUATION  AND  INTERPRETATION  OF 
INTANGIBLE  ASSETS 

1.  Introduction 120 

2.  Good-will  Defined 120 

3.  Value  of  Good-will  Dependent  on  Location       .      .  121 

4.  Good-will  Dependent  upon  the  Reputation  and  In- 

tegrity of  the  Firm 121 

5.  Good-will  Created  by  Established  Monopolies  .       .    122 

6.  The  Earning  Power  as  a  Factor  in  the  Valuation 

of  Good-will 123 


CONTENTS  xiii 

SECTION  PAGE 

7.  Transferability 124 

8.  Method  of  Valuing 124 

9.  Factors  to  Be  Eliminated  for  the  Purpose  of  Val- 

uation          126 

10.  Factors  Requiring  Careful  Scrutiny     ....  126 

11.  Mathematical  Results 128 

12.  Fictitious  Good-will 128 

13.  When  Good-will  Is  Created 129 

14.  Is  Good-will  of  a  Fluctuating  Value?  ....  130 

15.  Adjustment  of  Good-will  Account  in  Consolida- 

tions       132 

16.  Good-will  in  Consolidated  Balance  Sheet    .       .      .  133 

17.  Patents,  Trade-marks  and  Copyrights        .      .      .  134 

18.  Valuation  of  Patents 135 

19.  Valuation  of  Trade-marks 136 

20.  Valuation  of  Copyrights                   >.  137 

CHAPTER  IX 

VALUATION  AND  INTERPRETATION  OF 
CURRENT  ASSETS 

1.  Current  Assets  Defined 139 

2.  Cash  on  Hand     . 139 

3.  Cash  in  Bank 139 

4.  Investments  in  Stocks  and  Bonds 141 

5.  Classification  of  Permanent  Investments   .      .      .  141 

6.  Investments  in  the  Stocks  of  Allied  Companies       .  142 

7.  Investments  in  Outside  Companies 142 

8.  Investments  of  Insurance  Companies  and  Invest- 

ment Companies 143 

9.  Investments  of  Bankers  and  Brokers    ....  143 

10.  Treatment  of  Outside  Investments  in  Bonds  Dif- 

ferent from  That  of  Investment  in  Stocks    .      .  144 

11.  Securities  Purchased  for  Speculation  ....  145 

12.  Investments  in  the  Stocks  of  Mining  Companies    .  146 


xiv       FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

13.  General  Considerations  with  Reference  to  Valua- 

tion of  Securities 147 

14.  Notes  Receivable 147 

15.  Trade  Debtors 149 

16.  Treatment  of  Bad  Accounts 151 

17.  Treatment  of  Miscellaneous  Accounts  Receivable  152 

18.  Interest  on  Notes  or  Accounts  Receivable  .      .      .  152 

19.  Different  Methods  of  Providing  for  the  Reserve 

for  Bad  and  Doubtful  Debts 152 

CHAPTER  X 

VALUATION  AND  INTERPRETATION  OF 
ASSETS  (Continued) 

1.  Inventories ....    155 

2.  Valuation  of  the  Inventory  of  a  Trading  Concern  156 

3.  Should  Inventories  Be  Carried  at  Cost  or  at  Mar- 

ket Price? 156 

4.  Raw  Materials  Inventories  of  Manufacturing  Con- 

cerns     157 

5.  Work  in  Progress 157 

6.  Finished  Goods  Stock  Should  Be  Valued  at  Manu- 

facturing Cost 158 

7.  Treatment  of  Merchandise  Pledged  as  Collateral 

for  Loans 159 

8.  Possible  Deductions  from  Inventory  Valuations   .  159 

9.  Interpretation  of  Current  Assets 161 

10.     Importance   of  Right  Relation  Between   Current 

Liabilities  and  Current  Assets 161 

CHAPTER  XI 

VALUATION  AND  INTERPRETATION  OF 
DEFERRED  ASSETS 

1.  Meaning  of  Deferred  Assets 164 

2.  Organization  Expenses 165 


CONTENTS  xv 

SECTION  PAGE 

3.  Discount  on  the  Sale  of  Capital  Stock       .      .     ,.  166 

4.  Discounts  Allowed  on  Issue  of  Bonds  .      .      .      .167 

5.  Methods  of  Disposing  of  the  Bond  Discount  .      .  168 

6.  Treatment  of  Premiums  on  Bonds 170 

7.  Other  Examples  of  Deferred  Assets      ....  170 

CHAPTER  XII 
TREASURY  STOCK  AND  ITS  TREATMENT 

1.     Treasury  Stock  Defined 173 

£.     Disposition  of  Donation  Reserve  Credit     .      .      .  175 

3.  Acquisition   of  Treasury   Stock  Below  or  Above 

Par      ... 176 

4.  Stock  Donated  to  Cover  a  Deficit 177 

CHAPTER  XIII 
INTERPRETATION  OF  LIABILITIES 

1.  Liabilities  Defined  and  Classified 179 

2.  Bonded  Debt 180 

3.  Mortgage  Debts  and  Bonds 183 

4.  Notes  Payable 184 

5.  Trade  Creditors 185 

6.  Salaries  and  Wages  Accrued 185 

7.  Other  Liabilities 185 

8.  Ratio  of  Current  Assets  to  Current  Liabilities     .  186 

9.  Deferred  Liabilities  or  Deferred  Credits  to  Income  186 

10.  Contingent  Liabilities 187 

11.  Conclusions  to  Be  Inferred  from  the  Liabilities       .  188 

CHAPTER  XIV 

SURPLUS,  RESERVES  AND  DIVIDENDS 

1.  Definition  of  Surplus 195 

2.  Kinds  of  Surplus 195 


xvi       FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

3.  Relative  Importance  of  Surplus  and  Assets     .      .    196 

4.  Sources  of  Surplus 196 

5.  Surplus  Resulting  from  Business  Operations  .       .    196 

6.  Importance  of  Distinguishing  Between  Capital  and 

Revenue  Expenditure 196 

7.  Depreciation  as  an  Element  of  Cost     ....    197 

8.  Reserves  That  Are  Not  Part  of  Surplus    .       .       .    198 

9.  Inter-company   Profits    on   Inventory   Should  Be 

Eliminated  from  Surplus 198 

10.  Dividends  of  Subsidiary  Companies  Available  to 

the  Parent  Company 200 

11.  Surplus  from  Sale  of  Fixed  Assets 201 

1£.     Profits  Resulting  fronv  the  Sale  of  Investments     .    203 

13.  Profits  Resulting  from  Revaluation  of  Fixed  As- 

sets     203 

14.  Entries  on  Revaluation  Necessary  to  Adjust  Prop- 

erty Accounts 204 

15.  Value  of  Fixed  Assets  Is  Not  Affected  by  Eco- 

nomic Conditions 204 

16.  Entries    to    Record   Increase    Due    to    Economic 

Causes 206 

CHAPTER  XV 

SURPLUS,  RESERVES  AND  DIVIDENDS  (Continued) 

1.  Surplus  Contributed  at  the  Time  of  Incorporation  207 

2.  Distribution  of  Initial  Surplus 208 

3.  Secret  Reserves 208 

4.  Purpose  of  Secret  Reserves 209 

5.  Other  Purposes  of  Secret  Reserves 210 

6.  Propriety  vs.  Impropriety  of  Secret  Reserves        .    211 

7.  Disposition  of  the  Surplus 211 

8.  Surplus  Does  Not  Necessarily  Mean  Cash  .       .       .212 

9.  Distribution  of  Dividends 212 

10.  Characteristics  of  a  Dividend 212 


CONTENTS  xvii 

SECTION  PAGE 

11.  Considerations  Affecting  the  Declaration  of  Divi- 

dends      214 

12.  Capital  Expenditures  Charged  Against  Surplus    .  214* 

13.  Reserves  Created  Out  of  Surplus 215 

14.  Reserve  Account  Misnamed 215 

15.  Illegal  Dividends 215 

16.  Scrip  Dividends .216 

17.  Dividend  Policies 216 


CHAPTER  XVI 
SINKING  FUNDS  AND  OTHER  FUNDS 

1.  The  Theory  of  the  Sinking  Fund 218 

2.  The  Sinking  Fund  Reserve  a  Charge  Against  Prof- 

its           219 

3.  Funds  Distinguished  from  Reserves      ....  220 

4.  Sinking  Funds  Proper 221 

5.  The  Investment  of  the  Sinking  Fund    ....  221 

6.  Treatment  of  Interest  Earned  on  the  Sinking  Fund  222 

7.  Sinking  Fund  and  Reserve  Fund  Investments  .      .  222 

8.  Insurance  Funds   Should  Be  Adequate  to   Meet 

Losses 224 


CHAPTER  XVII 

RELATION  OF  WORKING  CAPITAL  AND 
INCOME  TO  ASSETS 

1.  Relation  of  Net  Income  to  Capital  Stock  .      .      .    226 

2.  Comments  upon  the  Above  Statement  ....    227 

3.  Ratio  of  Net  Income  to  Capital  Stock       .      .      .    228 

4.  Ratio  of  Net  Income  to  Total  Invested  Assets       .    228 

5.  Ratios  Based  on  Invested  Assets  Are  the  Proper 

Ratios  to  Employ 229 

6.  Relation  of  Working  Capital  to  Total  Assets  .      .   230 


xviii    FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

7.  Amount  of  Working  Capital  Needed  Depends  upon 

Nature  of  Business 230 

8.  No  Rule  for  Amount  of  Quick  Assets  Required  by 

Corporations 231 

9.  The  Economic  Status  of  Contributors  of  Capital 

to  a  Business  Enterprise 232 

10.  Is  Interest  on  Capital  Part  of  Cost  of  Production?  233 

11.  Difficulty  of  Selecting  Correct  Rate     ....  234 

12.  Inflation  of  Inventory  Values 235 

13.  Cost  and  Income  Confused 235 

CHAPTER  XVIII 

CONSOLIDATED  BALANCE  SHEETS 

1.  Reasons  for  Consolidations 237 

2.  Possible  Legal  Basis  for  Consolidated  Statements  238 

3.  Investments  Carrying  Less  than  Control  .       .      .  239 

4.  Carrying  at  Cost 239 

5.  Periodic  Revaluation 239 

6.  The  Equity  in  Surplus 240 

7.  Treatment  of  Dividends 240 

8.  Objection  to  Carrying  the  Investment  at  Cost       .  241 

9.  Revaluation  of  Investments  Is  Subject  to  Compli- 

cations          241 

10.  Oppressive  Tactics  to  Discharge  Minority  Inter- 

ests         242 

11.  Illustration 243 

CHAPTER  XIX 

CONSOLIDATED  BALANCE  SHEETS  (Continued) 

1.  Premium  on  Investments 250 

2.  Other  Methods  of  Carrying  Premium  on  Invest- 

ments      251 

3.  Discounts  on  Investments 252 


CONTENTS  xix 

SECTION  PAGE 

4.  Treatment  of  Deficits  Existing  in  Sub-companies  .  253 

5.  Protection  of  Minority  Interests 254 

6.  Capitalized  Surplus 254 

7.  Method  of  Treating  Surplus  Accounts  of  Acquired 

Companies 255 

8.  Other  Phases  of  Capitalized  Surplus     ....  255 

9.  Illustration  of  Capitalized  Surplus        ....  257 

10.  Unpaid  Cumulative  Dividends  of  Subsidiaries  .      .  258 

11.  When  Control  Is  Not  Complete 258 

12.  Overcoming  Disadvantages  of  Consolidated  State- 

ments     260 

13.  Interpretation  of  Consolidated  Statements       .      .  260 

14.  Value  of  Individual  Statements  to  Managing  Offi- 

cials        261 

15.  Credit  Risk  Viewpoint 262 

16.  Investment  Standpoint 262 

17.  Other  Forms  of  Consolidated  Statements  .      .      .  263 

CHAPTER  XX 
PRIVATE  BUDGETS 

1.  Purpose  and  Definition  of  Budgets       ....  273 

2.  The  Annual  Budget 273 

3.  Interim  Reconciliation  of  Estimate  with  Costs       .  274 

4.  The  Final  Statement 274 

5.  Value  and  Use  of  Estimates 274 

6.  Budgets  as  a  Means  of  Guidance 275 

7.  Special  Budgets 275 

8.  The  Sub-division  of  Budgets  into  Monthly  Periods  276 

9.  Pre-requisites  of  a  Budget 276 

10.  Budget  Routine 277 

11.  Sales  Department's  Duties  as  to  Budgets  .       .      .  278 

12.  Budgets  on  Four-week  instead  of  Calendar-month 

Basis 278 

13.  Duties  of  Production  Department 279 


xx       FINANCIAL  AND  BUSINESS  STATEMENTS 

SECTION  PAGE 

14.  Assembling  the  Data 280 

15.  Checking  the  Data  Assembled 282 

16.  Interim  Check  on  the  Budget 283 

17.  Other  Considerations  in  Budget  Making  .      .      .    284 

18.  Working  Back  from  the  Income  Statement       .       .    285 

19.  Departmental    Standards    Required    for    Budget 

Making 286 


CHAPTER  XXI 

MUNICIPAL  BUDGETS 

1.  Development  of  Municipal  Budgets      .....  289 

2.  Distinction  Between  Private  Budgets  and  Munici- 

pal Budgets 289 

3.  Borrowing  by  Municipal  and  Business  Organiza- 

tions Differentiated 291 

4.  Old-time  Budgets 292 

5.  The  Modern  Budget 293 

6.  The  Segregated  Budget 293 

7.  The  Lump-sum  Budget 294 

8.  A  Variation  of  the  Lump-sum  Budget  Plan     .       .  295 

9.  The  Essentials  of  Municipal  Budget  Preparation  295 

10.  Legal  Foundation  for  Budget  Necessary  .      .       .  296 

11.  The  Accounting  Foundation  in  Budget  Making     .  297 

12.  Statistical   Methods   in   Connection   with   Budget 

Reports 297 

13.  Budget  Machinery 298 

14.  Determining  the  Tax  Rate 299 

15.  Transfers  and  Charges  in  the  Budget  ....  300 

16.  Providing  in  the  Budget  for  Unforeseen  Needs       .  300 

17.  Other  Public  Budgets 301 

18.  Some  Fundamentals  in  Budget  Interpretation       .  301 

19.  Extending  the  Scope  of  the  Budget       ....  303 


CONTENTS  xxi 

CHAPTER  XXII 

INTERPRETATION  OF  PROFESSIONAL  REPORTS 

SECTION  PAGE 

1.  Criticism  Due  to  Improper  Interpretation      .      .   305 

2.  Interpretation  of  an  Auditor's  Certificate  .      .      .   305 

3.  Certification  as  to  Values  of  Real  Property  and 

Fixed  Assets 306 

4».     Certifying  to  the  Valuation  of  Inventories       .      .    307 

5.  Procedure  Where  Inventories  May  Not  Be  Relied 

Upon 308 

6.  An  Auditor  Not  Entirely  Absolved  by  Qualifica- 

tions from  Responsibility 309 

7.  Examples  of  Attempted  Fraud 309 

8.  Auditor's    Report    Regarding   Statement    of   Re- 

sponsibility as  to  Trade  Debts 311 

9.  Interpretation  of  Phrase  "Properly  Drawn  Up"  .    311 

10.  Omission  to  Furnish  Auditor's  Certificate  in  Pub- 

lished Report 312 

11.  Meagerness  of  Information  in  Published  Reports  313 

12.  Certificate  of  Profit 313 

13.  Reports  of  Appraisers 315 

14.  Basis  of  Valuation 316 

15.  Adjustment  of  Book  Values  to  Appraisal  Values  .  317 

16.  Reports  of  Engineers 318 

17.  Conclusion 318 


FINANCIAL  AND  BUSINESS 

STATEMENTS 

I  CHAPTER  I 

IMPORTANCE  OF  CLASSIFIED  INFORMATION 

1.  Present  need  for  classified  information. — Prob- 
'  ably  at  no  previous  period  in  our  economic  history 
has  it  been  so  important  to  the  business  man  as  it  now 
is  to  have  all  kinds  of  information  about  his  business 
I  available  to  him  in  classified  form.     With  the  growth 
of  modern  business,  with  specialization  and  standard- 
ization of  factor}*  and  office  routine,  it  has  become  in- 
!  creasingly  important  that  executives  and  their  im- 
mediate subordinates  should  have  the  right  kind  of 
statistical  information  about  the  activities  of  a  busi- 
ness. 

The  old  practice  of  closing  the  books  once  a  year 
in  order  to  determine  whether  a  profit  had  been  made 
or  a  loss  sustained  is  becoming  obsolete.  The  busi- 
ness man  of  today  wants  daily  information.  He 
wants,  also,  that  information  in  comparative  form  so 
he  can  tell  how  it  compares  with  that  of  a  month  ago, 
or  a  year  ago.     To  compete  successfully  with  other 

business  men  he  must  know  the  causes  that  have  cco- 

1 


%      FINANCIAL  AND  BUSINESS  STATEMENTS 

tributed  to  the  success  of  the  year's  sales,  as  well  as 
the  factors  that  have  caused  any  loss  during  the  year. 

2.  Classified  information  measures  efficiency. — 
Properly  classified  records  act  as  a  measure  of  effi- 
ciency. Factory  superintendents  and  other  depart- 
ment heads  may  endeavor  to  explain  the  reasons  for 
the  condition  of  business  as  disclosed  by  the  records. 
The  indisputable  fact,  however,  remains  that  the  rec- 
ords will  point  definitely  to  either  a  profit  or  a  loss. 

With  proper  records  before  him  the  executive  is 
enabled  to  determine  where  the  responsibility  for  the 
condition  of  his  plant  or  any  department  of  it  rests. 
He  is  then  in  a  position  to  strengthen  the  weak  points 
of  his  department  heads  and  to  help  them  develop  their 
strong  features. 

3.  Business  policies. — From  an  analytical  study  of 
the  classified  information  the  managerial  body  of  a 
business  enterprise  is  able  to  determine  the  future 
course  of  action.  If,  for  example,  the  results  show  that 
a  previous  advertising  campaign  increased  the  vol- 
ume of  business,  it  is  quite  likely  that  a  more  exten- 
sive advertising  policy  will  follow.  Similarly,  if 
the  records  show  that  while  the  volume  of  business 
has  increased,  the  cash  receipts  have  not  kept  a  pro- 
portionate pace,  assuming  that  the  terms  of  sale  are 
the  same,  it  is  evident  that  there  is  a  weakness  in 
the  credit  department  or  in  the  credit  policies.  This 
result,  if  not  offset  by  other  factors,  may  call  for  a 
restricted  policy  in  the  expansion  of  credits. 

At  this  time  more  than  at  any  other  it  is  obvious 


CLASSIFIED  INFORMATION  3 

that  the  business  man  must  base  his  action  regarding 
his  future  business  policies  upon  the  experience  of 
past  performances  as  shown  by  properly  classified 
records.     He  must  not  rely  on  memory. 

4.  How  outside  factors  affect  a  business  organiza- 
tion,— In  interpreting  a  set  of  financial  statements 
one  has  necessarily  to  put  together  many  related  but 
apparently  separate  facts  into  a  general  picture  which 
will  portray  in  compact  form  the  condition  of  the  or- 
ganization. One  must,  therefore,  not  only  read  into 
the  statements  facts  taken  from  a  set  of  books,  but  he 
must  also  consider  unrecorded  facts  as  well.  This 
point  will  be  discussed  in  greater  detail  later,  but  it  is 
mentioned  here  to  bring  home  the  effect  of  unrecorded 
factors  on  future  conditions.  Such  things  as  changes 
in  selling  plans,  increased  cost  of  labor,  increased 
freight  rates,  etc.,  all  will  have  a  direct  effect  on  the 
business.  Any  one  who  analyzes  financial  or  business 
statements  must  estimate  the  probable  future  condi- 
tions in  the  light  of  these  outside  factors.  Moreover, 
certain  adverse  results,  as  indicated  by  the  financial 
statements,  may  be  entirely  explained  and  accounted 
for  by  some  condition  which  is  only  temporary. 

Thus,  for  instance,  a  severe  flood  in  a  western  city 
might  have  caused  a  decrease  in  the  sales  of  a  busi- 
ness whose  greatest  volume  was  disposed  of  in  that 
territory.  Inasmuch  as  the  condition  was  only  tem- 
porary in  its  effect,  one  would  not  be  justified  in  bas- 
ing upon  the  net  results  shown  for  that  year  an 
opinion  concerning  the  usual  volume  of  business  done. 


4      FINANCIAL  AND  BUSINESS  STATEMENTS 

5.  Financial  statements  classified. — As  already 
mentioned  in  the  other  volumes  on  accounting  the 
principal  financial  statement  is  the  balance  sheet. 
This  statement  discloses  the  financial  condition  of  a 
business  at  a  particular  time.  It  is  well  for  the 
reader  to  bear  in  mind  at  this  point  that  a  balance 
sheet  is  only  an  expression  of  opinion  regarding  the 
financial  condition  of  a  business  at  a  given  time.  The 
importance  of  this  statement  will  be  made  evident 
later  on. 

The  next  statement  in  importance  is  the  profit  and 
loss,  or  income  statement,  sometimes  called  the  profit 
and  loss,  or  income  account.  This  statement  presents 
a  history  of  what  has  occurred  since  the  date  of  the 
last  balance  sheet. 

Each  of  these  statements  may  have  supporting 
schedules  showing  in  greater  detail  information  con- 
cerning some  factor  or  factors  of  the  business.  In  a 
large  undertaking,  both  the  balance  sheet  and  the 
profit  and  loss  statement,  will  usually  be  prepared  in 
detail  as  well  as  in  condensed  form. 

The  condensed  income  statement  usually  reveals 
only  the  general  tendencies  of  the  business.  One  has 
therefore  to  refer  to  supplementary  or  explanatory 
statements  that,  as  a  rule,  accompany  the  main  state- 
ments, for  the  details  of  the  various  transactions. 

6.  Statistical  information. — To  supplement  the  bal- 
ance sheet  and  income  statements  many  forms  of 
statistical  statements  are  often  prepared.  These 
statements  serve  the  purpose  of  explaining  many  of 


CLASSIFIED  INFORMATION  5 

the  items  that  appear  in  the  main  statements.  It  is 
self-evident  that  too  much  detail  cannot  be  conven- 
iently presented  in  a  single  statement,  if  it  is  to  be  of 
any  value.  It  is  a  well-known  fact  that  both  the  eyes 
and  the  mind  of  a  person  reading  a  statement  can 
grasp  only  a  limited  amount  of  material  at  any  one 
time.  It  stands  to  reason,  accordingly,  that  if  one  is 
confronted  with  many  columns  of  figures,  even  the 
main  essentials  of  the  business  may  escape  his  atten- 
tion. It  is  therefore  important  to  prepare  special 
schedules  and  statistical  statements  apart  from  the 
main  statements. 

As  a  rule,  statistical  statements  proper  take  up  what 
might  be  called  the  non-financial  side  of  the  business. 
Thus,  for  instance,  plant  statements  are  often  pre- 
pared to  cover  the  unit  production,  or  possibly  the 
unit  cost.  To  be  more  concrete,  a  telephone  com- 
pany, for  example,  will  prepare  a  plant  statement 
showing  the  amount  and  cost  of  all  new  construction 
work  carried  out.  Such  a  statement  would  show  in 
terms  of  miles  the  amount  of  wire  put  up,  distinguish- 
ing between  copper,  iron,  and  steel  wire.  It  will 
show  also  the  number  of  exchanges,  or  private  tele- 
phones installed,  and  other  items  of  similar  nature. 

Statements  of  this  kind  are  often  made  because 
they  are  used  as  a  means  of  throwing  additional  light 
on  the  condition  of  the  business,  showing  its  progres- 
sion or  retrogression  in  what  might  be  called  the 
physical  aspect  of  the  business. 

7.  Departmental  statements. — Just  as  it  is  impor- 


6      FINANCIAL  AND  BUSINESS  STATEMENTS 

tant  to  obtain  classified  business  information  on  the 
condition  of  a  business  as  a  whole,  it  is  equally  im- 
portant to  follow  out  the  results  of  different  depart- 
ments or  of  individual  functions.  It  is  thus  advis- 
able to  prepare  special  profit  and  loss  statements 
from  each  department  of  a  business.  It  is  equally 
desirable  to  prepare  departmental  statistics. 

In  order  to  manage  his  department  right,  the  head 
should  have  before  him  regularly  prepared  statements 
that  will  keep  him  in  close  touch  with  the  detail 
and  routine  of  his  department.  A  monthly  con- 
densed statement,  supported  perhaps  by  weekly  sum- 
maries and  daily  reports,  giving  full  details  of  the 
revenue  and  expenses  of  his  department,  reveals  to 
him  in  chronological  order,  the  facts  of  all  the  routine 
and  constructive  end  of  his  department. 

8.  Purpose  of  financial  statements. — The  main  pur- 
pose of  a  financial  statement  is  to  show  the  condition 
of  a  business  in  a  more  condensed  form  than  is  avail- 
able from  an  examination  of  all  the  facts  shown  in  the 
records.  This  information,  if  arranged  in  an  intelli- 
gible and  readable  form,  will  be  used  by  the  manage- 
ment and  persons  outside  of  the  management,  such 
as  stockholders,  bankers  and  investors.  These  state- 
ments will  be  examined  to  check  up  the  efficiency  in 
operation  and  in  management.  They  will  also  be 
used  to  determine  the  value  of  the  assets,  the  present 
financial  condition,  and  the  probable  future  earnings. 

9.  Prerequisites  of  the  executive. — An  executive 
who  is  to  make  the  most  of  various  statements  which 


CLASSIFIED  INFORMATION  7 

are  brought  to  his  attention  not  only  must  possess  a 
broad  knowledge  but  also  must  be  able  to  draw  upon 
many  sources  of  information.  He  must  understand 
the  basis  upon  which  assets  are  valued,  and  be  com- 
petent to  pass  upon  the  relative  values  of  various  ac- 
counts or  groups  of  accounts  as  compared  with  other 
and  different  groups.  Moreover,  he  must  have  a 
knowledge  of  accounting  terms  and  their  true  mean- 
ing, and  a  knowledge  of  the  principles  underlying  the 
construction  of  financial  statements.  Finally,  he 
must  be  able  to  pick  out  the  false  from  the  true  and 
to  know  what  is  omitted  from  a  statement  as  well  as 
what  has  been  furnished.  It  will  be  readily  seen, 
therefore,  that  sometimes  it  is  vastly  more  important 
to  deduce  the  information  which  the  accounts  fail 
to  disclose  than  to  understand  that  which  they  re- 
flect. 

10.  Requisites  of  proper  financial  statements .; — ■■ 
The  variety  in  the  kinds  of  business  and  the  different 
physical  or  artificial  conditions  accompanying  them 
makes  impracticable  a  single  type  of  accounting  sys- 
tem. The  form  of  financial  statements  which  will 
best  serve  the  individual  purposes  of  any  concern  must 
be  particularly  adapted  to  that  undertaking.  No 
one  form  of  statement  will  be  equally  serviceable  in 
different  organizations. 

11.  Financial  statements  should  be  comparative. — 
While  it  is  clear  that  much  information  can  be  ob- 
tained from  a  single  balance  sheet,  and  from  a  profit 
and  loss,  or  income  statement  of  one  period,  it  is 


8       FINANCIAL  AND  BUSINESS  STATEMENTS 

equally  obvious  that  changes  in  conditions  made  dur- 
ing a  given  period  can  be  regarded  as  satisfactory 
only  when  they  represent  an  improvement  over  a 
previous  period.  The  effect  of  new  policies,  changes 
in  management,  and  the  like,  cannot  be  fully  meas- 
ured unless  the  results,  as  shown  in  statements,  are 
given  in  comparative  form.  This  holds  true  not  only 
with  regard  to  main  income  statements  and  balance 
sheets,  but  also  as  regards  sub-schedules  and  depart- 
mental statements.  By  observing  the  effect  of  a  par- 
ticular policy  for  several  years  the  management  is 
in  a  far  better  position  to  estimate  the  value  and  the 
effect  of  it. 

12.  Importance  of  the  personal  element. — Mention 
has  been  made  of  the  importance  of  outside  factors  in 
connection  with  the  interpretation  of  financial  state- 
ments. The  personal  element  is  perhaps  the  most 
varying  as  well  as  the  most  important  factor.  Mis- 
takes in  management  often  offset  all  of  the  favor- 
able characteristics  which  a  business  may  possess.  It 
is  therefore  important  to  give  proper  consideration 
to  the  individual  efficiency  of  every  man  in  an  admin- 
istrative position. 

Harmony  and  cooperation  of  effort  is  a  salient  fea- 
ture of  the  human  element  question.  Individual  stars 
will  not  bring  success  to  a  business  unless  they  are 
willing  to  cooperate  with  the  heads  of  allied  depart- 
ments. 

Expansion  in  one  department  at  the  expense  of 
another  or  in  undue  proportion  as  compared  with 


CLASSIFIED  INFORMATION  9 

others  will  frequently  result  in  internal  strife  or  fi- 
nancial loss. 

To  obtain  a  clear  idea  of  the  possibilities  and  op- 
portunities of  a  business,  one  must  be  able  to  ap- 
preciate not  only  its  present  condition  but  also  the 
advantages  and  opportunities,  if  any,  that  will  accrue 
to  it  in  the  future. 

13.  Consideration  of  outside  factors. — Many  out- 
side factors,  as  already  stated,  will  affect  costs  and 
sales,  but  they  cannot  be  discovered  from  the  recorded 
data.  The  demand  for  most  products  is  frequently 
an  uncertain  item.  One  must  therefore  ascertain 
what  probable  future  demand  will  be  made.  The  de- 
mand for  specialties  and  commodities  that  are  on  the 
border  line  of  staples  will  naturally  be  subject  to 
great  fluctuations. 

In  connection  with  costs  the  probable  supply  of 
raw  materials  is  an  important  consideration.  Assum- 
ing that  there  is  a  steady  demand  for  the  product,  we 
must  be  sure  that  the  cost  of  the  raw  materials  will 
not  rise  and  that  supplies  will  not  be  entirely  cut  off. 

Labor  problems  are  frequently  the  rock  on  which 
the  success  of  a  business  is  wrecked.  Sources  of  la- 
bor, the  probability  of  strikes,  and  the  development 
of  unions  are  important  outside  factors  affecting 
costs  and  sales.  Transportation  facilities  and  trans- 
portation costs  are  likewise  important  in  this  respect. 
They  must  all  be  ascertained  and  considered  if  the 
financial  results  of  a  business  are  to  be  properly  in- 
terpreted. 


10     FINANCIAL  AND  BUSINESS  STATEMENTS 

14.  Executive's  reasons  for  a  study  of  financial 
statements. — Three  considerations  should  lead  the  ex- 
ecutive to  study  financial  statements. 

First,  he  must  be  able  to  get  all  possible  data  on 
the  condition  of  his  own  business.  That  can  be  ob- 
tained only  from  reports  prepared  in  proper  form. 

Secondly,  he  is  interested  in  furnishing  to  others 
honest  and  exact  statements  of  the  condition  of  his 
business. 

Thirdly,  he  should  be  able  to  read  the  financial  state- 
ments of  others  so  as  to  get  a  true  picture  in  his  own 
mind  of  the  business  conditions  of  those  with  whom  he 
deals. 

15.  Stockholders'  reasons  for  a  study  of  financial 
statements. — Inasmuch  as  the  stockholder  has  not  the 
first-hand  information  regarding  the  inside  factors 
which  the  managing  officials  have,  he  must  necessarily 
read  "between  the  lines."  His  chief  use  of  the  finan- 
cial statements  will  be  to  employ  them  in  deciding 
upon  the  value  of  the  services  rendered  by  his  board 
of  directors.  He  will  use  the  statements  also  to  guide 
him  in  his  control  over  his  representatives  in  the  man- 
agement of  the  company. 

The  particular  interest  of  the  stockholder  is  in  the 
payment  of  dividends  or  the  return  on  invested  cap- 
ital. He  is  also  interested  in  knowing  that  such  pay- 
ments are  made  from  revenues  earned  and  realized. 
He  is  therefore  concerned  to  know  whether  the  prop- 
erty has  been  fully  maintained  and  whether  all  income 
has  been  honestly  and  faithfully  recorded. 


CLASSIFIED  INFORMATION  11 

16.  Information  as  a  guide  to  legislation. — The  im- 
portance of  classified  information  upon  legislation  is 
very  seldom  realized.  In  the  recent  agitation  of  rail- 
way employes  for  increased  wages,  the  figures  of  cost 
varied  from  twenty  million  dollars,  the  estimate 
of  railway  employes,  to  one  hundred  million  dollars, 
the  estimate  of  the  managers.  There  should  not  be 
such  a  wide  margin  between  the  estimates. 

We  have  been  told  that  child  labor  was  necessary 
for  the  existence  of  the  cotton  industry  of  the  South. 
Reliable  facts  in  support  of  this  assertion  have  not 
been  forthcoming. 

When  the  agitation  of  a  ten-hour  working  day  was  at 
its  height,  manufacturers  asserted  that  industry  would 
be  bankrupt.  The  outcome  happily  was  not  what  the 
pessimistic  manufacturers  declared  it  would  be. 

Do  we  know  the  industrial  cost  of  a  universal  eight- 
hour  working  day?  Classified  information,  properly 
interpreted  and  analyzed,  will  furnish  an  answer  to 
that  question.  Have  we  not  rather  been  content  in 
many  cases  with  the  gathering  of  statistics  and  the 
tabulation  of  results,  rather  than  attempting  to 
analyze  and  properly  interpret  the  information  which 
we  already  have?  In  fact,  the  lack  of  public  faith  in 
the  statistics  which  are  offered  in  the  discussion  of  the 
great  social  and  economic  problems  of  the  present 
day,  arises  in  part  from  the  erroneous  interpretation 
and  unscientific  analysis,  or  the  lack  of  proper  inter- 
pretation and  analysis,  of  the  mass  of  tabulation  and 
statistics  which  we  now  possess. 

XXII— 5 


12    FINANCIAL  AND  BUSINESS  STATEMENTS 


REVIEW 

What  business  purposes  does  classified  information  serve? 

What  are  the  sources  of  the  information  which  is  useful  in 
judging  the  condition  of  a  business? 

How  do  comparative  figures  add  to  the  significance  of  any 
financial  statement?  Name  some  of  the  outside  factors  which 
affect  the  interpretation  of  the  financial  statement. 

What  reasons  for  desiring  classified  business  information  has 
the  executive?     The  stockholder? 

How  might  facts,  properly  ascertained  and  correctly  inter- 
preted, guide  legislation  and  public  administration? 


CHAPTER  II 

STATISTICAL  AND  GRAPHICAL  STATEMENTS 

1.  Purpose  and  scope  of  business  statistics. — The 
reader  has  already  been  familiarized  with  the  value 
of  statistical  statements  as  supplements  to  financial 
statements.  By  business  statistics  we  mean  the  rec- 
ords that  grow  up  out  of  the  operations  of  industrial 
and  mercantile  establishments.  As  a  rule,  these  sta- 
tistics are  as  varied  in  their  contents  as  the  different 
lines  of  business  from  which  they  are  taken.  Thus, 
the  records  of  public  service  corporations  will  differ 
widely  from  those  of  manufacturing  or  mercantile  es- 
tablishments. 

When  the  prevailing  type  of  business  was  the  gen- 
eral country  store,  statistical  records  of  operations 
were  impracticable.  As  business  became  more  and 
more  specialized,  accurate  cost  and  sales  records  be- 
came possible.  As  industry  became  concentrated  in 
its  ownership,  comparisons  of  the  operations  of  dif- 
ferent plants  under  the  same  control  was  an  inevi- 
table consequence.  Thus  was  formed  a  body  of  rec- 
ords sufficiently  extensive  to  merit  the  name  of  busi- 
ness statistics. 

The  demand  of  the  business  man  for  information 
concerning  every  detail  of  his  business  has  resulted  in 

13 


14    FINANCIAL  AND  BUSINESS  STATEMENTS 

the  invention  of  a  large  number  of  mechanical  devices 
that  permit  the  gathering  of  an  increasing  amount  of 
statistical  information.  A  large  part  of  this  material 
is  furnished  by  modern  accounting  methods.  The 
old-fashioned  bookkeeping  was  confined  in  a  large 
measure  to  recording  receipts  and  disbursements. 
Modern  accounting  analyzes  the  transactions  which 
give  rise  to  these  effects.  It  groups  them  in  classes ;  it 
measures  service  as  well  as  financial  results  and  brings 
the  two  into  proper  relations,  one  with  the  other. 

2.  Official  and  business  statistics, — Business  statis- 
tics, as  distinguished  from  government  statistics,  are 
the  practical  result  of  the  tendencies  in  modern  busi- 
ness toward  specialization  and  toward  an  increased 
size  in  individual  enterprises.  Some  modern  business 
concerns  have  become  so  extensive  that  their  adminis- 
tration, as  pointed  out  in  the  Text  on  "Factory  and 
Office  Administration,"  is  in  many  respects  compa- 
rable to  that  of  cities  and  states,  and  branches  of  na- 
tional governments.  Indeed,  it  would  seem  that  at 
times  the  problems  of  business  concerns  are  in- 
finitely more  complex  and  difficult  than  those  of  gov- 
ernment. 

As  business  approaches  in  its  administrative  prob- 
lems more  and  more  closely  the  operations  of  public 
authorities,  it  is  not  surprising  that  it  should  avail  it- 
self to  a  greater  extent  of  methods  which  have  long 
been  established  in  government  practice.  From  this 
adoption  of  government  methods  comes  a  growing  use 
of  statistical  statements  in  business  management,  and 


STATISTICAL  STATEMENTS  15 

the  increasing  frequency  of  definitely  organized  sta- 
tistical departments  in  business  concerns. 

People  sometimes  think  of  government  statistics  as 
being  gathered  to  meet  some  fancied  need  or  to  satisfy 
an  idle  curiosity.  It  must  not  be  overlooked  that 
these  statistics  have  their  root  in  some  real  need  of 
government,  or  the  necessary  basis  for  transacting  its 
business. 

In  other  words,  it  is  not  mere  habit  or  routine  which 
leads  the  governments  of  the  world  to  publish  each 
year  a  vast  quantity  of  books  crammed  with  official 
statistics.  On  the  contrary,  it  is  done  for  definite, 
practical  purposes.  The  larger  part  of  these  sta- 
tistics is  designed  as  a  basis  for  action. 

Thus  the  census  of  the  United  States  Government, 
which  involves  the  employment  of  many  thousands  of 
persons  and  the  expenditure  of  many  millions  of  dol- 
lars, had  its  origin  in  the  necessity  of  determining  the 
basis  of  representation  in  Congress. 

Similar  illustrations  are  found  in  the  statistical  rec- 
ords pertaining  to  revenues,  expenditures  and  public 
debt. 

3.  The  contents  of  business  statistics. — As  each  line 
of  business  has  its  own  peculiar  operations  to  record,  it 
would  be  ridiculous  to  attempt,  in  this  growing  field, 
to  classify  the  various  kinds  of  statistics  which  might 
arise.  What  is  needed  in  any  particular  business  can 
best  be  judged  by  those  who  are  engaged  in  it.  Ex- 
perience shows  that  when  thought  is  given  to  this  mat- 
ter the  volume  of  records  often  becomes  very  consid- 


16    FINANCIAL  AND  BUSINESS  STATEMENTS 

erable.  It  is  quite  as  possible  to  overdo  the  gather- 
ing of  such  records  as  to  neglect  them.  The  informa- 
tion which  can  be  presented  in  statistical  form,  should 
first  be  carefully  weighed,  and  its  value  estimated  be- 
fore elaborate  preparations  for  securing  such  data 
are  provided. 

4.  Uses  of  business  statistics. — It  would  be  equally 
futile  to  seek  to  classify  the  various  uses  to  which  sta- 
tistics may  be  put  in  the  conduct  of  a  business.  At 
best,  a  general  treatment  of  the  subject  can  give  only 
some  suggestions  of  this  nature.  This  can  best  be 
done  by  a  rather  full  treatment  of  their  use  in  some 
definite  phase  of  business  administration.  Because  of 
their  importance  in  the  general  scheme  of  business  or- 
ganization, departmental  reports  have  been  chosen  as 
the  subject  of  this  special  study. 

5.  How  much  information  should  department  heads 
be  given? — Some  managers  believe  that  the  head  of  a 
branch  should  not  be  informed  as  to  the  amount  of 
profits  made  by  his  branch.  They  feel  that  the  man- 
ager might  use  the  information  as  a  lever  for  securing 
an  increase  in  salary.  If  it  is  desired  to  reduce  the 
apparent  profits  of  the  branch  and  at  the  same  time 
allow  the  manager  to  have  the  results  in  dollars  and 
cents,  this  can  be  accomplished  thru  the  medium  of  an 
arbitrary  overhead  charge.  When  the  statement  of 
financial  results  is  given  to  the  branch  manager,  the 
gross  profits  will  be  shown.  From  the  gross  profit 
will  be  deducted  the  amount  of  the  arbitrary  charge 
for  overhead,  which  will,  of  course,  reduce  the  net 


STATISTICAL  STATEMENTS  17 

profit.  In  this  way,  the  real  profitableness  of  the 
branch  may  be  concealed  from  the  branch  manager, 
who  will  not  know  the  details  of  the  overhead  charge. 

There  is  no  real  reason  why  department  heads 
should  be  kept  in  the  dark  as  to  the  progress  which 
is  made  by  their  departments.  Of  course,  a  depart- 
ment head  need  not  be  informed  as  to  what  is  going 
on  in  another  department,  nor  should  he  be  entitled 
to  information  as  to  the  condition  of  the  business  as 
a  whole.  But,  the  department  manager  will  not  have 
that  personal  interest  in  initiating  new  policies  or  put- 
ting new  projects  into  operation  unless  he  can  learn 
the  financial  results  of  these  undertakings.  The  de- 
partment heads  will  be  able  to  guide  themselves  in 
new  projects  by  having  at  hand  records  of  the  re- 
sults obtained  by  previous  undertakings  of  a  similar 
nature. 

6.  Record  of  orders  and  sales. — The  manager 
should  receive  a  statement  of  the  total  orders  each 
month,  or  if  the  department  is  a  large  one  and  is  doing 
a  large  volume  of  business,  these  reports  may  be  made 
up  daily.  The  report  should  show  the  orders  re- 
ceived up  to  the  beginning  of  the  present  month,  the 
orders  of  the  present  month,  and  the  orders  received 
during  the  preceding  month.  This  information  will 
be  accumulated  from  day  to  day  or  month  to  month. 
From  this  amount  should  be  deducted  the  amount  of 
orders  delivered  and  the  amount  of  cancellations,  leav- 
ing as  the  balance  the  amount  of  unfilled  orders  on 
hand  at  the  present  time.     This  information  should  be 


18    FINANCIAL  AND  BUSINESS  STATEMENTS 

shown  in  comparative  form,  giving  the  results  of  one 
or  more  preceding  years,  so  that  the  department  man- 
ager can  endeavor  to  increase  his  sales,  speed  up  de- 
liveries or,  if  orders  fall  off,  to  determine  the  causes 
thereof. 

A  similar  comparative  record  of  the  sales  should  be 
furnished  him.  The  sales  for  the  current  fiscal  pe- 
riod up  to  the  first  of  the  month,  the  sales  of  the 
month,  and  the  sales  for  the  preceding  month  should 
be  set  forth;  the  record  of  sales  should  show  also  the 
amount  of  the  returns  and  allowances  to  date.  In  ad- 
dition, the  sales  records  of  the  individual  salesmen  and 
saleswomen  in  the  departments  should  be  furnished. 

7.  Inventory  and  purchase  records  should  be  avail- 
able.— Inventory  and  purchase  records  should  be  fur- 
nished at  periodic  intervals.  There  is  always  great 
danger  of  a  department  manager's  overbuying,  or  al- 
lowing stock  to  accumulate,  thus  tying  up  an  unneces- 
sary amount  of  capital  in  inventories.  The  informa- 
tion furnished  to  the  department  managers  should 
give  the  inventory  on  hand  at  the  last  report  date,  the 
purchases  during  the  interval,  and  from  the  aggre- 
gate of  these  two  amounts,  the  cost  of  the  sales 
should  be  deducted.  The  last  amount  may  be  con- 
veniently found,  either  by  reducing  the  sales  by  the 
amount  of  the  departmental  mark-up,  or  by  reducing 
the  sales  by  the  amount  of  average  gross  profits  real- 
ized by  the  department  in  preceding  periods. 

There  should  also  be  furnished  to  the  department 
head,  if  he  is  allowed  to  purchase  his  own  material  or 


STATISTICAL  STATEMENTS  19 

merchandise,  a  record  of  the  amount  of  merchandise 
purchase  orders  as  yet  unfilled.  If  some  of  the 
purchase  orders  apply  to  the  current  season  and 
some  to  a  later  season,  this  information  should  be 
clearly  set  forth.  With  the  information  as  to  his 
present  stock,  and  the  amount  of  undelivered  pur- 
chase orders,  the  department  head  is  enabled  to  guide 
himself  in  meeting  the  requirements  for  stock. 

8.  Analytical  expense  statements, — The  depart- 
ment manager  should  also  be  furnished  with  a  depart- 
mental analytical  statement  of  expenses  incurred  or 
charged  to  his  department  during  the  period.  As  al- 
ready mentioned  if  the  executives  do  not  wish  the  man- 
ager to  know  the  actual  net  profits  of  the  department, 
they  may,  of  course,  load  this  expense  statement  with 
an  arbitrary  and  fixed  amount  of  overhead. 

9.  Departmental  profit  and  loss  statements. — The 
information  with  reference  to  sales,  purchases  and  ex- 
penses should  then  be  gathered  together  into  a  de- 
partmental profit  and  loss  account  or  statement,  ar- 
ranged in  comparative  form,  covering  similar  prior 
periods,  so  that  the  department  manager  may  be  able 
to  know  how  his  department  has  progressed  or  fallen 
behind.  These  statements  will  also  prove  of  ad- 
vantage to  the  department  head  if  he  is  called  upon 
subsequently  to  furnish  the  executives  with  a  budget 
estimate,  or  the  probable  income  and  expense  of  his 
department  for  an  ensuing  period. 

10.  Results  expressed  in  percentages. — Percentage 
statements  indicate  the  trend  of  business  more  clearlv 


20     FINANCIAL  AND  BUSINESS  STATEMENTS 

than  statements  worked  up  in  dollars  and  cents. 
Thus,  for  example,  the  department  manager  should 
be  given  the  ratio  of  gross  profits  to  sales;  the  ratio 
of  net  profits  to  sales;  the  ratio  of  salary  to  sales; 
and  the  ratio  of  advertising,  interest  and  total  expense 
to  sales.  These  expense  statements,  as  indicated 
above,  should  be  furnished  in  comparative  form.  The 
fluctuations  in  percentages  constitute  an  accurate 
gauge  of  departmental  or  company  operation,  undis- 
turbed by  increases  or  decreases  in  the  amount  of 
business  done.  In  addition  to  these  statements,  the 
department  manager  should  be  furnished  with  the 
turnover  of  his  department  for  the  period. 

Some  executives  object  to  the  expense  entailed  and 
time  consumed  in  preparing  these  reports.  The  time 
consumed  may  be  materially  reduced  by  the  intro- 
duction of  printed  forms,  and  the  calculations  may  be 
shortened  materially  thru  the  use  of  calculating  de- 
vices. Others  say  that  the  information  would  not  be 
used  by  the  department  heads.  Often  this  latter 
statement  is  true,  because  the  department  heads  are 
not  competent  to  analyze  many  of  the  reports  that 
would  be  presented  to  them.  We  occasionally 
find  a  good  merchandise  man  who  will  succeed  in 
making  money  for  his  department  without  the  aid 
of  comparative  reports  of  progress.  This  type  of 
man,  however,  is  rather  unusual,  and  it  may  not  be 
wide  of  the  mark  to  say  that  even  a  good  merchandise 
man  can  profit  by  a  study  of  results  presented  to  him 
in  proper  form. 


STATISTICAL  STATEMENTS  21 

In  some  organizations  it  is  customary  to  keep  a  per- 
petual inventory  and  stock  record  by  sizes  and  quali- 
ties, and  it  is  advantageous  to  furnish  the  head  of  a 
department,  from  time  to  time,  with  stock  sheets  show- 
ing the  condition  of  the  stock.  He  will  then  be  en- 
abled to  determine  the  lines  or  sizes  or  qualities,  which 
are  selling,  and  those  which  are  moving  slowly,  and 
concentrate  his  attention  on  the  problem  of  getting 
rid  of  the  stock  that  is  accumulating,  or  for  which, 
perhaps,  the  proper  demand  has  not  been  created. 

11.  Form  of  statistical  statements. — The  statisti- 
cal statement  is  characterized  by  two  things,  first  that 
it  is  expressed  in  figures,  and  second,  that  it  relates  to 
a  number  of  things  of  which  it  is  a  condensed  sum- 
mary. The  fact  that  a  given  make  of  automobile  is 
sold  for  $3,000  is  not  statistical,  but  if  the  statement 
is  that  automobiles  range  in  price  from  $500  to  $5,000 
it  has  the  marks  of  a  statistical  statement.  It  is  a 
fact  expressed  in  figures  relating  to  automobiles  in 
general. 

All  statistical  statements  express  or  imply  a  com- 
parison. It  is  of  the  utmost  importance  that  this 
comparison  be  correctly  stated  and  that  the  conse- 
quences which  are  derived  from  it  be  rightly  estimated. 

The  reader  will  recall  what  was  stated  regarding 
fallacious  statistics,  at  the  close  of  the  first  chapter. 
Statistical  errors  and  statistical  fallacies  are  for  the 
most  part  not  mistakes  of  figures,  but  wrong  thinking 
about  figures.  It  is  evident  that  no  rules  can  be  de- 
vised to  save  people  from  illogical  thought;  the  most 


22    FINANCIAL  AND  BUSINESS  STATEMENTS 

that  can  be  done,  in  a  negative  way,  is  to  avoid  in- 
viting incorrect  conclusions  by  the  manner  of  stating 
the  problem,  and,  in  a  positive  way,  to  call  attention 
to  the  need  of  careful  analysis. 

12.  Statistical  comparisons. — The  principal  com- 
parisons with  which  statistics  deal,  concern  (1)  the 
same  things  at  different  times,  (2)  a  thing  in  rela- 
tion to  some  larger  thing  of  which  it  may  be  a  part, 
and  (3)  one  thing  in  its  relation  to  something  else 
which  is  supposed  to  influence  it.  Some  of  the  chief 
characteristics  of  these  principal  types  of  comparison 
deserve  brief  consideration  in  connection  with  the  uses 
of  statistics  in  business. 

13.  Past  and  present  performances. — One  of  the 
most  usual  of  statements  which  are  met  in  business 
life,  is  the  comparison  of  current  results  with  past 
achievements,  the  sales  of  this  year,  month  or  week 
with  those  of  last  year,  month  or  week.  In  all  such 
comparisons  the  two  elements  should  have  equal 
weight,  tho  it  is  an  instinctive  tendency  of  the  mind 
to  regard  what  is  more  remote  as  something  normal 
with  which  to  compare  what  has  more  recently  been 
accomplished. 

14.  Results,  year  by  year. — Thus  men  of  business 
will  explain  why  this  year's  sales  exceeded  those  of 
last  year.  It  never  occurs  to  them  to  explain  why 
last  year's  sales  failed  to  reach  the  level  of  this  year's, 
tho  in  some  cases  this  would  be  the  most  reasonable 
way  of  stating  the  case.  It  may  be  that  this  year 
represents  normal  conditions,  while  last  year  had  ab- 
normally small  sales. 


STATISTICAL  STATEMENTS  23 

Because  of  this  tendency  to  accept  the  earlier  dates 
as  normal,  it  is  well  to  choose  what  is  instinctively  re- 
garded as  the  basis  of  the  comparison  with  great  care, 
and  to  be  sure  that  it  actually  is  of  normal  character 
for  the  purpose  in  hand.  A  comparison  of  the  busi- 
ness done  in  1915,  for  example,  with  that  of  1914 
would  not  necessarily  be  incorrect,  but  might  easily 
lead  to  false  impressions.  Figures  for  the  year  1913, 
representing  less  disturbed  business  conditions,  should 
be  added  to  make  the  full  meaning  of  the  1915  figures 
apparent. 

15.  Results,  month  by  month. — What  is  empha- 
sized regarding  yearly  results  applies  with  equal  force 
to  monthly  results.  We  must  assure  ourselves  in 
comparing  results,  month  by  month,  that  there  is  no 
seasonal  variation  which  would  affect  them.  Proper 
comparisons  are  possible  only  when  the  corresponding 
month  of  a  previous  normal  year  is  considered. 

A  point  that  often  escapes  attention  is,  that  when 
any  given  facts  occur  with  a  very  even  distribution 
thruout  the  year,  the  difference  between  one  month 
and  another  will  be  very  slight.  Oftentimes  the  dif- 
ference is  fully  accounted  for  by  the  fact  that  the 
months  are  not  of  equal  length.  It  is  therefore  a 
good  rule,  when  the  difference  is  slight,  to  reduce  the 
figures  to  daily  averages  and  make  comparisons  on 
this  basis. 

16.  Results,  week  by  week. — The  longer  the  period 
of  time  to  which  the  figures  relate,  the  more  likely  is 
the  effect  of  accidental  variations  to  be  diminished. 


24    FINANCIAL  AND  BUSINESS  STATEMENTS 

It  is  never  wholly  eliminated.  Conversely,  the 
smaller  the  period  of  time,  the  greater  the  caution 
which  must  be  used.  Comparisons  of  one  week  with 
another,  whether  the  previous  week  or  the  correspond- 
ing week  of  last  year,  which  ignore  special  holidays, 
weather  conditions  and  the  like,  prompt  to  wrong  con- 
clusions. To  illustrate,  a  shoe  dealer  would  not  be 
likely  to  compare  sales  of  rubbers  in  the  first  week  of 
November  in  one  year  with  the  same  week  in  another 
without  first  asking  himself  how  the  weather  at  the 
two  periods  compared.  The  use  of  the  obvious  illus- 
tration is  intended  merely  to  call  attention  to  the 
fact  that  similar  conditions  may  in  less  degree  bring 
similar  effects,  and  that  these  are  not  negligible  quan- 
tities. It  is  therefore  advisable,  when  conclusions  are 
drawn  from  statistics,  to  qualify  the  comparison  by 
the  addition  of  the  phrase  "all  other  things  being 
equal." 

17.  Results,  day  by  day, — Daily  comparisons  must 
be  handled  with  the  utmost  care.  That  is  obvious,  be- 
cause it  is  so  easy  for  some  purely  accidental  circum- 
stances to  throw  these  comparisons  out  of  gear. 

In  the  summer  of  1916,  when  the  public  was  watch- 
ing day  by  day  the  figures  of  American  exports  the 
New  York  Journal  of  Commerce  called  attention  to 
the  fact  that  altho  Saturday  was  a  favorite  sailing  day 
for  ocean  steamers,  the  reported  exports  for  Satur- 
day were  invariably  less  than  for  other  days  of  the 
week.  Investigation  showed  that  the  daily  returns 
reported  to  the  press  were  not  those  that  were  made 


STATISTICAL  STATEMENTS  25 

each  day,  but  those  tabulated  each  day.  As  Saturday 
was  a  short  working  day  in  the  government  offices, 
fewer  figures  were  prepared  on  that  day  and  hence  the 
falling  off  in  exports  reported. 

18.  Establishing  standards  of  comparison.  The 
obvious  remedy  for  some  of  the  difficulties  noted  in 
the  preceding  sections  is  to  establish  proper  bases 
for  comparison.  These  usually  take  the  form  of  a 
fair  average  of  past  conditions,  but  under  certain  cir- 
cumstances it  is  possible  to  establish  a  normal  result 
and  observe  the  variation  of  actual  figures  from  it. 
To  secure  a  proper  basis  for  comparisons  it  may  be 
necessary  to  take  averages  covering  a  long  period  of 
years.  Suppose  the  question  to  concern  sales  of 
September,  1916.  It  may  be  necessary,  in  order  to 
obtain  the  necessary  basis  for  a  judgment,  to  make 
calculations  as  complicated  as  those  which  follow: 

SALES 


Year 

Year  ending 

i  Sept.  30 

Sept 

smber 

Per  cent 

Per  cent 

Per  cent 

of 

of 

of 

Amount  1901-1910 

Amount 

1901-1910 

year's  sales 

1901-1910 

(average)  $522,000 

$45,000 

8.6 

1911 

530,000 

101.5 

45,800 

101.8 

8.6 

1912 

546,000 

104.6 

47,800 

106.2 

8.8 

1913 

550,000 

105.4 

48,000 

106.7 

8.7 

1914 

480,000 

92.0 

32,000 

71.1 

6.7 

1915 

560,000 

107.3 

57,000 

126.7 

10.2 

1916 

640,000 

122.6 

54,500 

121.1 

8.5 

If  in  this  case  we  had  before  us  only  the  results  for 
September,  1915  and  1916,  the  only  thing  we  could 
see  would  be  a  falling  off  in  the  latter  year.  What 
that  meant  we  should  not  be  able  to  appreciate.     If 


86    FINANCIAL  AND  BUSINESS  STATEMENTS 

we  added  merely  the  figures  for  1914,  we  might  be 
still  more  confused.  But  with  all  the  figures  above 
given  before  us  we  can  know  the  situation  thoroly. 
The  general  volume  of  business  has  been  subject  to 
fluctuation.  In  the  main  it  increases,  but  in  1914  ad- 
verse business  conditions  brought  about  a  decrease. 
September  sales  until  1913  moved  along  at  about  the 
same  rate  as  the  business  in  general.  In  1914  they 
were  smaller  compared  with  1901-1910  than  were  the 
sales  of  the  year.  This  was,  it  will  be  remembered, 
about  the  lowest  point  in  business  activity  of  that  year. 
In  1915  they  increased  more  than  the  general  volume 
of  sales;  the  recovery  in  other  words  gained  impetus 
toward  the  end  of  the  year  ending  September  30. 
But  apparently  the  growth  did  not  continue  thru  the 
next  year  at  the  same  rate. 

19.  The  percentage. — One  of  the  most  frequent  de- 
vices for  making  figures  comparable  is  the  reduction 
to  percentages.  This  is  essential  when  the  units  com- 
pared are  of  different  sizes.  That  one  concern  has  an 
advertising  expense  of  $50,000,  and  another  one  of 
$120,000  per  year,  tells  us  nothing  unless  we  know  the 
volume  of  sales  to  which  these  figures  relate.  Even 
then  we  must  reduce  them  to  a  common  unit. 

In  the  illustration  given  in  the  preceding  section, 
the  percentage  of  the  September  sales  in  relation  to 
the  total  sales  tells  the  same  story  as  the  other  figures 
but  in  a  different  way. 

In  discussing  a  series  of  percentages  care  should  be 
taken  not  to  express  the  difference  between  the  num- 


STATISTICAL  STATEMENTS  27 

bers  of  the  series  as  so  much  per  cent  unless  this  is 
strictly  what  is  meant.  If  the  series  of  percentages 
compared  is  A,  78;  B,  82;  and  C,  96;  we  not  infre- 
quently hear  it  stated  that  B  is  4  per  cent  higher  than 
A,  while  C  is  18  per  cent  higher  than  A.  This  is  not 
the  fact,  as  these  differences  are  points,  not  percent- 
ages. To  express  them  in  percentages  A  must  be 
taken  as  the  base,  and  it  will  be  found  that  B  is  5.1 
per  cent  above  A,  while  C  is  23.1  per  cent  above  A. 

When  a  percentage  has  been  calculated  for  the 
numbers  of  a  series,  as  the  months  of  a  year,  or  a 
quarter,  and  the  average  percentage  for  the  whole 
period  is  then  wanted,  the  mistake  is  sometimes  made 
of  calculating  this  average  from  the  individual  per- 
centages and  not  from  the  totals  of  the  original  fig- 
ures.    The  following  supposed  case  will  illustrate. 

Sales  Selling  Expenses  Per  cent 

January    $  5638                    $  6,432  11.4 

February    *        38,962                        5,896  15.1 

March 74,839                        6,824  9.1 


1st  quarter    $170,049  $19,152  11.2 

The  percentage  given  for  the  quarter  is  the  cor- 
rect one  based  upon  the  division  of  the  total  selling  ex- 
pense by  the  total  sales.  Had  the  percentages  for 
the  three  months  been  added  and  the  total  divided  by 
three,  the  result  would  have  been  11.8. 

20.  The  ratio. — The  ratio  between  one  fact  and  an- 
other is  of  frequent  use  in  official  and  business  sta- 
tistics. Instances  are  shown  in  the  per  capita  con- 
sumption of  wheat,  liquors  and  other  commodities ;  in 

XXII — i 


28    FINANCIAL  AND  BUSINESS  STATEMENTS 

railway  receipts  per  mile  of  road,  in  costs  per  unit 
of  product  and  in  many  others.  Here  again  the  cau- 
tion should  be  given  that  such  comparisons  may  tell 
as  much  about  one  factor  as  another.  Comparison  of 
per  capita  sales  of  farm  implements  in  Rhode  Island 
and  North  Dakota  for  example,  would  not  indicate 
much  about  the  character  of  farming  in  these  two  re- 
gions, but  chiefly  that  one  was  a  farming  country  and 
the  other  was  not.  Sometimes  such  ambiguity  can 
be  avoided  by  a  better  choice  of  things  compared. 
Consumption  of  fertilizers  for  example  would  be  com- 
pared more  appropriately  with  the  acres  of  improved 
land  in  farms  in  the  different  states  than  with  the 
number  of  the  population. 

21.  Graphic  statements. — It  is  a  variation  of  the 
usual  statistical  form  of  the  statement  when  the  facts 
to  be  expressed  are  not  given  in  figures,  but  are  shown 
in  pictorial  form,  by  means  of  lines,  curves,  surfaces 
and  other  geometric  figures.  Such  graphic  methods 
are  coming  to  play  a  larger  and  larger  part  in  the 
business  world.  Executives,  sales  managers,  and  ad- 
vertising men  are  finding  a  constantly  increasing  use 
for  such  methods  of  presentation  as  a  means  of  grasp- 
ing rapidly  the  results  of  business  administration 
which  are  vital  to  the  work  in  which  they  are  engaged. 

The  use  of  charts  and  diagrams,  or  to  borrow  the 
term  which  the  scientists  have  introduced  into  the  lan- 
guage and  which  is  making  its  appearance  in  general 
writings,  of  "graphs,"  owes  its  growing -frequency  to 
the  apparent  ease  with  which  such  representation  of 


STATISTICAL  STATEMENTS  29 

facts  can  be  understood.  There  are  many  persons  to 
whom  series  of  figures  carry  no  significant  message, 
but  who  can  readily  see  the  proportions  of  things, 
their  increase  and  decrease,  and  the  other  relations 
which  are  expressed  by  statistics,  when  they  are  shown 
in  the  form  of  the  diagram  or  chart.  It  may  well  be 
that  this  applies  to  the  majority  of  persons,  and  that 
only  those  trained  in  the  use  of  figures  can  grasp  their 
real  significance.  This,  however,  is  a  training  which 
comes  with  practice,  and  because  of  the  limitation  of 
the  graphic  methods  is  not  to  be  overlooked. 

One  of  the  disadvantages  of  the  otherwise  excellent 
graphic  method  of  presenting  facts  is,  that  while  the 
diagrams  give  to  the  eye  a  very  definite  impression, 
it  is  oftentimes  difficult  to  reproduce  this  impression 
in  language.  In  other  words,  diagrams  as  such  can- 
not be  quoted.  On  the  scales  in  which  they  are 
usually  presented,  exact  measurements  are  impracti- 
cable. It  follows  therefore,  that  the  use  of  graphics  is 
to  emphasize  a  general  impression,  and  in  order  that 
this  impression  may  be  as  concrete  as  possible  it  is 
a  useful  rule,  too  often  neglected,  that  the  facts  dis- 
played by  line  or  solid  should  at  the  same  time  be 
given  in  terms  of  figures. 

22.  The  appeal  to  the  eye. — The  purpose  of  graphi- 
cal presentations  is  to  make  an  appeal  to  the  eye,  and 
it  follows  at  once  that  this  appeal  must  be  simple  and 
direct.  The  diagram  should  not  impose  too  great  a 
burden  on  the  vision,  or  too  fine  a  discrimination  be- 
tween the  points  which  are  depicted.     When  the  dia- 


30     FINANCIAL  AND  BUSINESS  STATEMENTS 


gram  is  made  by  means  of  lines  drawn  to  a  scale,  there 
is  oftentimes  a  temptation  to  put  too  much  on  the 
diagram,  with  the  result  that  there  are  often  sev- 
eral intersecting  lines.  Without  the  use  of  color, 
and  this  is  in  most  cases  not  available,  it  is  very  diffi- 
cult to  draw,  at  the  best,  more  than  two  or  three  lines 
which  can  be  clearly  distinguished  one  from  another. 
Hence  the  best  usage  in  charts  of  this  character  calls 


u  □ 


<s 

s? 

B 


B 


B 


Figure  1.     Ix  each  of  these  comparisons  A  is  eight  times  as  large  as  B. 

for  not  more  than  two  or  three  lines,  and  this,  of 
course,  means  a  decided  limitation  upon  the  amount  of 
material  which  can  be  displayed  in  a  given  space. 

Where  the  eye  is  called  upon  to  judge  relative  size 
as,  for  instance,  when  the  exports  of  different  years  or 
the  exports  of  different  countries  are  compared,  the 
most  effective  presentation  is  the  line  diagram.  The 
use  of  squares,  circles  or  other  surfaces,  and  especially 
flat  representation  of  solid  bodies,  is  to  be  avoided. 


STATISTICAL  STATEMENTS  31 

Perhaps  the  greatest  sinners  against  this  rule  of  sim- 
plicity are  those  who  address  themselves  to  the  least 
intelligent  audience,  and  who  in  school  books  and  in 
magazines  of  popular  circulation,  represent,  for  in- 
stance, the  exports  of  different  countries  by  pictures  of 
sheep,  ingots ,  of  gold,  bales  of  cotton  or  hogsheads  of 
wine,  of  different  sizes.  The  foregoing  illustration 
will  make  this  point  clear,  and  speaks  so  plainly  for 
itself  that  additional  comment  is  not  necessary. 

23.  Curves. — The  most  frequent  way  in  which 
graphical  statements  are  made  is  by  the  use  of  the 
line,  or  as  it  is  sometimes  technically  called,  "curve," 
in  which  the  height  of  the  curve  from  the  base  meas- 
ures the  magnitude  of  the  phenomenon  in  question, 
while  the  distance  from  the  left-hand  side  of  the  page 
represents  the  period  of  time  to  which  the  facts  relate. 

The  rule  of  simplicity  makes  it  advisable  that  all 
distances  should  be  measured  by  the  eye  from  the  same 
base.  If  we  disregard  this  rule,  and  try  to  represent 
different  elements  which  enter  into  the  problem  by 
superimposing  one  on  the  other,  with  the  thought  that 
in  this  way  we  obtain  an  aggregate,  the  result  is  dis- 
astrous. Only  two  lines  in  the  entire  chart  are  clear, 
the  first  above  the  base  and  the  line  which  represents 
the  aggregate.  The  other  lines  cannot  easily  be  read 
by  the  eye,  and  if  we  want  to  observe  their  tendency 
they  must  be  taken  out  of  the  chart  and  redrawn  so 
that  for  each  of  them  there  is  a  uniform  base  from 
which  to  measure  the  height.  Where  the-  lines  are 
drawn  from  the  same  base,  it  is  sometimes  expedient 


32    FINANCIAL  AND  BUSINESS  STATEMENTS 

to  draw  each  line  in  a  separate  chart  on  a  uniform 
scale. 

The  preparation  of  line  charts  requires  considerable 
care  lest  false  impressions  be  given.  One  of  the  fre- 
quent failings  of  the  charts  in  common  use  is  that 
they  are  incomplete.  They  give  only  that  part  of 
the  chart  which  contains  the  line  and  do  not  indicate 
the  distance  of  this  line  from  the  base.  In  the  use  of 
such  partial  charts  it  is  quite  possible  to  give  very 
different  impressions  as  to  variations  by  changing  the 
scale  of  the  chart.  This  is  illustrated  in  the  four  charts 
which  follow,  representing  the  same  sequence  of  facts. 
They  refer  to  the  average  price  per  pound  of  prime 
contract  lard,  as  reported  by  the  United  States 
Bureau  of  Labor  Statistics  from  1890  to  1899.  Each 
of  the  four  lines  given  represents  the  same  facts.  In 
A  and  B  the  difference  is  in  the  height  assigned  to  the 
several  prices.  In  C  and  D  the  difference  lies  in  the 
width  assigned  to  successive  years. 

It  is  plain  that  neither  of  the  charts  A  and  B  is 
absolutely  incorrect,  but  both  are  incomplete.  In  the 
case  of  chart  A,  the  zero  line  would  be  approximately 
one  and  a  quarter  inches  below  the  line  indicating  10 
cents,  while  in  the  case  of  chart  B  this  distance 
would  be  two  and  a  half  inches.  The  consequence  of 
giving  only  a  part  of  the  charts  is  that  in  one  case  the 
fluctuations  appear  inconsiderable  and  in  the  other 
very  marked.  It  will  be  noted  that  in  these  charts  the 
same  amount  of  space  has  been  given  for  each  year. 
It  may  also  be  noted  that  the  line  becomes  more  even 


STATISTICAL  STATEMENTS 


33 


i»-    ca    10   * 


— i 


«  o   a    o    n    »    id    »r 


I" 


N      »     IO    ♦ 


34    FINANCIAL  AND  BUSINESS  STATEMENTS 

when  a  large  space  is  given  to  each  month,  and  more 
jagged  when  the  space  is  reduced  (Charts  C  and  D). 

Because  of  these  peculiarities  of  the  lines  it  is  well 
not  to  place  too  much  reliance  upon  the  comparison 
which  results  from  placing  side  by  side  two  charts 
which  are  drawn  on  a  different  scale.  In  such  cases 
the  conclusion  drawn  from  the  comparison  might  be 
called  correct,  but  it  is  advisable  also  to  have  the 
actual  figures  by  which  to  test  the  apparent  conclu- 
sions to  be  drawn  from  the  graphic  statements.  If 
the  charts  can  be  reduced  to  some  common  measure 
as,  for  instance,  percentage  above  or  below  the  aver- 
age for  the  period,  the  comparison  becomes  much 
safer. 

24.  Need  of  caution  in  interpretation. — Whether 
the  statistical  facts  be  expressed  in  figures  or  in  charts 
too  much  emphasis  cannot  be  placed  upon  the  need  of 
extreme  caution  in  the  interpretation  of  the  facts  re- 
corded. No  golden  rules  can  be  devised  which  will 
keep  a  man  out  of  the  pitfalls  which  beset  him  in  this 
field.  But  if  he  brings  to  the  analysis  of  facts  the 
qualities  of  caution  and  the  habit  of  thoro  examina- 
tion of  matters  from  all  points  of  view,  he  will  find 
that  statistics,  whether  in  tabular  or  graphic  form,  are 
a  powerful  aid  in  the  proper  apprehension  of  business 

conditions. 

REVIEW 

Why  have  we  seen  in  recent  years  a  considerable  development 
of  business  statistics? 

Describe  the  character  of  the  statistics  which  would  aid  a 
department  manager  in  getting  the  best  results  from  his  work. 


<      STATISTICAL  STATEMENTS 


35 


Define  a  statistical  statement.  What  types  of  comparison  does 
it  commonly  express  or  imply? 

Name  from  your  own  experience  instances  in  which  com- 
parisons of  one  type  or  another  have  been  used  in  business. 

Describe  various  forms  of  graphic  presentation  of  statistical 
facts;  and  explain  the  advantages  and  disadvantages  of  the 
graphic  method. 


CHAPTER  III 

AUXILIARY  STATEMENTS 

1.  Schedule  of  accounts  receivable. — The  reader 
has  already  noted  that  the  principal  statements  which 
the  manager  will  receive  at  the  end  of  a  stated  period 
— say,  a  year,  will  be  the  balance  sheet  and  the  profit 
and  loss,  or  income  statement,  covering  the  business  as 
a  whole  for  a  given  period.  As  a  rule,  these  state- 
ments will  be  submitted  in  comparative  form,  and 
they  will  be  supported  by  schedules  that  will  show  the 
operation  of  each  department. 

The  manager  of  a  business  will  quite  often  require 
statements  that  will  give  information  of  the  business 
in  a  form  that  will  enable  him  to  study  certain  fea- 
tures. This  will  depend,  of  course,  upon  the  nature 
of  the  particular  business.  Frequently,  the  schedule 
of  accounts  receivable  is  prepared  to  show  the  amount 
due  from  each  customer  and  the  time  when  the  amount 
is  due.  Often,  this  schedule  is  prepared  in  a  form  to 
show  the  amount  of  the  balances  from  one  to  thirty 
days  old,  from  thirty  to  sixty  days  old,  and  over  sixty 
days  old. 

When  the  number  of  accounts  receivable  is  large 
and  the  amounts  involved  are  comparatively  small,  it 

36 


AUXILIARY  STATEMENTS  37 

is  not  advisable  to  have  a  detailed  schedule.  In  such 
cases  it  is  better  for  the  manager  to  provide  an  auto- 
matic separation  of  the  delinquent  accounts  from  the 
accounts  that  are  in  good  standing,  and  to  provide  for 
a  proper  system  of  control,  both  for  the  delinquent 
ledger  and  for  the  ledger  containing  the  accounts  in 
good  standing.  By  analyzing  the  delinquent  ac- 
counts and  referring  to  the  amount  of  each,  as  com- 
pared with  preceding  periods,  the  manager  will  be 
able  to  check  up  the  efficiency  of  the  collection  de- 
partment. 

2.  Statements  of  new  customers. — A  manager  may 
often  find  it  advisable  to  require  reports  on  the  num- 
ber of  new  accounts  opened  during  the  business  pe- 
riod and  the  amount  of  sales  to  the  new  customers. 
He  should,  at  the  same  time,*  have  reported  to  him 
the  names  of  old  customers  who  have  not  purchased 
during  the  period,  or  whose  purchases  have  fallen  be- 
low those  of  previous  periods.  A  sufficient  amount 
of  attention  is  usually  given  to  this  particular  feature 
of  a  business.  Investigation,  however,  may  disclose 
unsatisfactory  conditions  that  would  otherwise  not  be 
brought  to  the  attention  of  the  management.  The 
preparation  of  such  a  list  will  act  as  a  sort  of  internal 
check  on  conditions  that  may  inadvertently  have  es- 
caped the  eye  of  the  management. 

Complaints  from  customers,  in  some  cases,  are  not 
brought  to  the  attention  of  the  manager.  A  customer 
of  a  house  feels  disgruntled  at  the  treatment  he  has 
received;  he  may  not  make  any  complaint,  but  will 


38    FINANCIAL  AND  BUSINESS  STATEMENTS 

place  his  future  orders  with  other  concerns.  If  the 
manager  has  before  him  the  information  mentioned 
above,  namely,  new  accounts  opened  and  old  ac- 
counts from  which  no  business  has  been  received  dur- 
ing the  present  period,  it  must  prove  invaluable  to 
him. 

3.  Importance  from  management  standpoint  of 
notes  taken  from  customers. — When  it  is  the  custom 
to  take  notes  from  customers  in  settlement  of  their  ac- 
counts, it  is  advisable  that  the  amount  of  notes  received 
from  each  customer  be  reported  at  regular  intervals. 
It  is  also  advisable  to  have  reported  at  the  same  time 
the  amount  which  such  customers  owe  on  open  ac- 
counts. In  addition,  if  any  of  the  customers'  notes 
have  been  discounted  and  have  not  as  yet  matured, 
the  information  on  them  should  also  be  included.  It 
will  be  readily  seen  that  a  report  of  this  character  will, 
at  all  times,  disclose  to  the  manager  the  condition  of  a 
customer's  account.  This  is  especially  true  if  the  ac- 
count is  one  which  is  being  "nursed"  by  the  manage- 
ment. 

4.  Schedule  of  inventory. — It  is  advisable  that  the 
management  pay  considerable  attention  to  the  in- 
ventory schedules  that  are  prepared.  It  very  often 
happens  that  department  managers  allow  dead  stock 
to  accumulate — a  condition  which  would  have  been 
disclosed  had  the  management  properly  examined  the 
detailed  inventory.  The  author  recommends  that  a 
schedule  be  prepared  showing  the  amount  of  the  in- 
ventory located  in  different  departments  or  different 


AUXILIARY  STATEMENTS  39 

warehouses,  the  amount  of  insurance  carried  on  and 
for  each  warehouse,  and  so  on. 

If  a  perpetual  inventory  system  is  maintained,  the 
manager  should  keep  in  touch  with  any  irregularities 
which  may  be  disclosed  in  checking  out  the  cost  or 
book  inventories  by  physical  inspection  of  the  stores  or 
the  stock  room.  Carelessness  in  charging  out  mater- 
ial, or  in  transferring  it  to  other  departments,  or  petty 
thieving  may  be  the  cause  of  these  discrepancies. 
They  should  in  all  cases  be  investigated  and  corrected. 

5.  Production  reports. — The  management  should 
also  receive  reports  of  production.  The  quantity  of 
goods,  or  of  classes,  manufactured  during  the  period, 
should  be  reported  by  departments,  or  by  manufactur- 
ing functions,  together  with  the  unit  cost.  This  en- 
ables the  management  to  inquire  into  the  causes  of  re- 
duced volume  of  production,  and  locate  and  stop  the 
waste. 

6.  Sales  analyses. — Inasmuch  as  there  can  be  no 
profit  until  the  product  is  actually  sold,  the  sales  de- 
partment becomes  the  balance  of  power  in  any  busi- 
ness establishment.  Accordingly,  a  study  of  success- 
ful business  houses  will  generally  reveal  the  fact  that 
their  success  is  due  chiefly  to:  a  careful  study  of 
markets;  the  training  of  salesmen;  the  building  of 
sales  arguments ;  and  effective  advertising. 

Analysis  of  sales  according  to  periods  of  time,  ter- 
ritories, salesmen,  branch  offices,  classes  of  goods,  lines 
of  industry,  and  the  like,  should  always  be  available. 
Quite  often,  as  this  information  is  of  a  statistical  na- 


40    FINANCIAL  AND  BUSINESS  STATEMENTS 

ture  and  not  recorded  in  the  books  of  accounts,  it  is 
overlooked.  Too  much  emphasis  cannot  be  placed 
upon  the  fact  that  if  this  information  is  properly  pre- 
sented and  interpreted,  it  is  bound  to  be  a  valuable 
fund  of  information  for  the  progressive  executive. 
To  illustrate :  If  sales  are  not  analyzed  by  territories, 
and  results  are  compared  with  a  preceding  period,  it 
may  be  found  that  while  the  sales  have  increased  in 
total,  the  firm  has  been  losing  ground  in  one  section  of 
the  country,  and  gaining  it  in  another.  With  ana- 
lyzed information  on  sales  before  him,  the  executive  is 
in  a  position  to  know  in  which  territories  the  sales  have 
decreased  and  to  concentrate  upon  those  territories. 

In  the  same  manner,  a  failure  to  analyze  sales  by 
the  classes  of  goods  will  not  reveal  to  the  manager  the 
particular  lines  which  are  selling  and  those  which  are 
not. 

Care  must  be  taken,  too,  that  the  information  col- 
lected prove  not  too  costly.  However,  the  main- 
tenance of  a  small  statistical  department,  prop- 
erly equipped  with  mechanical  devices,  will,  in  a  large 
majority  of  cases,  pay  for  the  installation  and  the  ex- 
pense of  operation  in  a  short  time,  by  reason  of  the 
valuable  information  disclosed. 

7.  Expense  schedules. — In  almost  every  business 
there  are  certain  expense  items  which,  if  properly  ex- 
amined, will  reveal  much  more  information  than  might 
otherwise  appear.  It  is,  of  course,  advisable  to  pro- 
vide a  sufficient  number  of  expense  accounts  in  the 
classification  of  accounts  so  that  items  of  like  nature 


AUXILIARY  STATEMENTS  41 

only  will  be  charged  to  a  single  expense  account. 
When,  however,  this  method  has  not  been  followed,  it 
is  advisable  for  the  executive  to  require  an  analysis  of 
the  expense  account.  The  miscellaneous  expense  ac- 
count often  becomes  a  very  tempting  hiding  place  for 
questionable  items  or  improper  outlays.  In  these 
statements  are  set  forth  the  various  kinds  of  expenses 
which  make  up  the  total  of  this  account.  They  may 
reveal  unsuspected  leaks  and  be  the  means  of  stop- 
ping them. 

Similarly,  it  is  even  advisable  to  attach  certain  def- 
inite earmarks  to  the  expense  account  analyzed ;  thus, 
expenses  for  advertising  and  sales-promotion  items 
should  be  analyzed,  if  possible,  by  classes  of  goods  ad- 
vertised. If  this  is  done  it  is  advisable  to  make  a 
separation  between  advertising  expense  which  can  be 
definitely  allocated  to  a  given  line  of  products,  and 
expenses  of  a  general  advertising  nature. 

8.  Cash  report. — The  manager  should  have  a 
proper  statement  of  cash  on  hand  and  in  banks  made 
to  him  daily.  This  statement  should  show  the  re- 
ceipts, the  disbursements,  the  balance  at  the  beginning 
of  the  day,  and  the  bank  balances  at  the  end  of  the 
day.  Comparative  figures  for  the  preceding  periods 
should  also  be  included. 

In  connection  with  the  cash  statement  there  should 
be  included  a  schedule  of  the  maturing  notes  receiv- 
able and  of  notes  payable.  As  already  pointed  out,  no 
figure  or  amount  is  valuable  by  itself.  The  value  of 
any  information  in  a  report  lies  chiefly  in  its  relation 


42     FINANCIAL  AND  BUSINESS  STATEMENTS 

to  other  figures  properly  comparable  with  it.  For 
this  reason,  all  reports,  whether  daily  or  monthly, 
should  give  corresponding  information  for  one  or 
more  preceding  periods. 

A  statement  of  receipts  and  disbursements  will  give 
the  executive  a  knowledge  of  the  manner  in  which  the 
business  organization  is  handling  its  cash  transac- 
tions. A  comparison  of  results  with  several  pre- 
ceding periods  will  reveal  the  wisdom  with  which 
payments  are  made,  and  will  indicate  also  whether  or 
not  financial  difficulties  have  been  encountered  at  dif- 
ferent times. 

9.  False  statements. — By  false  statements  the 
author  does  not  mean  only  intentionally  misleading 
ones.  They  may  include  statements  which  have  been 
prepared  from  insufficient  records,  or  from  records 
which  do  not  present  a  clear  view  of  the  actual  condi- 
tions of  a  business. 

A  misconception  of  a  balance  sheet  may  result  from 
several  different  causes,  of  which  the  principal  ones 
are:  (1)  vagueness  of  the  terminology  and  use  of 
technical  words  not  readily  understood  by  the  layman; 
(2)  improper  accounting  records  on  which  the  state- 
ment is  based;  (3)  intentional  misrepresentation  of 
the  management;  and  (4)  improperly  prepared  state- 
ments. 

It  may  be  admitted  that  technical  terminology  can- 
not be  entirely  avoided.  Therefore,  the  layman  must 
make  himself  acquainted  with  the  meaning  of  certain 
technical  terms.     But  when  terms  of  a  controversial 


AUXILIARY  STATEMENTS  43 

nature  are  used,  they  should  be  made  clear  by  descrip- 
tions. Certain  lines  of  business  will  have  accounts 
peculiar  to  the  business,  and  while  the  technical 
phraseology  in  these  instances  cannot  be  entirely 
avoided,  the  meaning  can  be  made  more  intelligible 
by  means  of  an  added  description. 

That  an  accounting  system  can  always  furnish  ab- 
solutely accurate  information  in  all  cases,  no  one 
would  contend.  The  reader  has  already  been  cau- 
tioned that  the  best  that  accounting  systems  can  do  is 
to  reflect  the  scientifically  prepared  estimate  of  condi- 
tions. This  uncertainty  appears  principally  in  con- 
nection with  the  valuation  placed  on  assets.  The  diffi- 
culties encountered  in  this  particular  connection  have 
already  been  touched  upon  in  previous  volumes  and 
will  be  more  fully  discussed  in  this  volume  later.  For 
the  present  it  is  sufficient  to  say,  that  where  there  are 
no  outside  criterions  and  no  other  means  of  compari- 
sons with  other  forms,  it  is  advisable  to  make  a  de- 
tailed study  of  each  asset  before  one  can  pass  upon 
the  condition  of  a  business  as  reflected  in  a  given  state- 
ment. 

10.  Intentional  misrepresentation. — Misrepresen- 
tations which  are  intentional  may  be  accomplished 
in  a  number  of  ways.  Quite  often  they  are  the  result 
of  a  combination  of  the  false  with  just  enough  truth  to 
make  it  seem  reasonable.  Absolute  falsehoods  can  be 
detected  directly.  But  the  grouping  of  various  ac- 
counts so  that  the  good  is  put  with  the  bad  makes  it 
difficult  for  any  one  to  pass  a  correct  judgment.     No 

XXII— 5 


44     FINANCIAL  AND  BUSINESS  STATEMENTS 

knowledge  of  accounting  principles  will  disclose  this 
fact  under  ordinary  conditions. 

11.  Incorrect  preparation. — Misstatements,  due  to 
the  incorrect  grouping  of  accounts,  the  omission  of 
pertinent  information,  and  mistakes  in  inventory 
preparation  or  in  pricing,  will  all  result  in  false  state- 
ments. Fortunately,  however,  the  form  of  statement 
preparation  is  becoming  so  well  systematized  that  er- 
rors of  this  nature  will  be  easily  detected.  If  it  is 
borne  in  mind  that  there  must  be  omissions  among 
the  various  groups  shown  in  any  statement,  a  trained 
observer  will  easily  detect  false  statements. 

A  statement  that  presents  too  favorable  a  condi- 
tion should  be  questioned  as  closely  as  one  that  shows 
an  unfavorable  condition.  By  going  back  to  figures 
and  tracing  them  to  their  sources,  one  may  often  dis- 
cover the  errors. 

If  the  profits  of  a  particular  department  are  un- 
usually large  the  executive  should  examine  the  rela- 
tive charges  of  the  various  groups  of  expense.  By 
comparing  the  relative  percentages  of  profits  in  one 
department  with  the  cost  of  similar  departments,  one 
may  be  able  to  pick  out  the  section  which  has  been 
misstated. 

As  a  case  in  point,  if  the  manufacturing  costs  of  one 
firm  were  found  proportionately  less  than  the  manu- 
facturing costs  of  others  in  the  same  line,  it  would  in- 
dicate that  the  cost  had  been  arbitrarily  reduced,  or 
that  the  sales  had  been  fictitiously  increased  without  a 
corresponding  increase  being  made  in  expenses.     The 


AUXILIARY  STATEMENTS  45 

relation  among  the  various  groups  of  accounts  will, 
as  a  rule,  remain  fairly  constant  in  all  firms  engaged 
in  the  same  line  of  business.  If,  therefore,  the  rela- 
tionship is  not  the  same,  it  indicates  either  false  state- 
ments or  inefficient  management.  A  successful 
method  of  detecting  such  things  is  to  make  a  compari- 
son of  the  present  period  with  that  of  preceding  pe- 
riods. As  a  rule,  when  a  statement  is  incorrectly  pre- 
pared, intentionally  or  otherwise,  it  will  be  obvious  to 
the  trained  observer,  because  it  is  difficult  to  obtain 
relative  amounts  in  all  accounts. 

12.  Preparation  of  statements  for  executives. — Un- 
doubtedly the  best  use  for  financial  statements  is  to 
have  them  interpreted  by  the  financial  or  accounting 
officer  who  is  best  fitted  to  take  up  that  work.  He 
will  prepare  a  general  summary  of  the  condition  of 
the  business  as  a  whole,  in  which' he  will  call  attention 
to  the  favorable  and  unfavorable  conditions,  as  re- 
flected in  the  statements  themselves,  and  endeavor  to 
trace  these  statements  back  to  the  departments  where 
they  originated. 

This  summary  will  give  a  detailed  analysis  of  the 
business  showing  just  what  changes,  if  any,  favor- 
able or  unfavorable,  have  taken  place.  As  a  rule,  the 
attention  of  the  board  of  directors  will  be  called  to  the 
features  which  the  interpreting  officer  thinks  require 
attention,  and  to  those  departments  which  have  made  a 
relatively  poor  showing.  Commendation  will  be 
given  to  the  departments  which  have  done  especially 
well. 


46    FINANCIAL  AND  BUSINESS  STATEMENTS 

Because  of  his  greater  knowledge  of  accounting 
and  his  familiarity  with  the  financial  conditions 
of  the  business,  the  treasurer,  or  his  assistant,  is  in  a 
better  position  to  analyze  the  condition  of  each  de- 
partment, as  shown  by  the  records,  with  perhaps  bet- 
ter success  than  any  other  officer. 

Even  at  the  present  time,  it  is  doubtful  whether 
the  great  majority  of  business  executives  fully  ap- 
preciate the  importance  of  the  accounting  and  statis- 
tical departments.  To  quote  from  Mr.  James  Logan, 
Chairman  of  the  Executive  Board  of  the  United 
States  Envelop  Company: 

The  processes  of  modern  business  are  like  the  functions  of 
a  complicated  machine  and  the  executive  must  organize  every 
part  of  his  establishment  as  carefully  as  an  inventor.  Or- 
ganization means  running  the  machine  with  all  its  parts  in 
harmony.  The  management  of  the  large  corporation  is  or- 
ganized thought,  exactly  as  a  machine  is  the  organized 
thought  of  an  inventor.  The  executive  must  be  a  specialist 
along  the  lines  which  make  for  efficiency  in  administration. 
He  must  have  the  God-given  quality  —  capacity  for  inven- 
tion in  organization.  There  is  real  invention  in  the  field  of 
organization  and  administration  the  same  as  in  the  field  of 
mechanics.  Efficient  organization  is  an  asset  which  counts 
for  commercial  and  industrial  success  more  now  than  ever 
before.1 

REVIEW 

In  what  ways  can  the  accounts  receivable  be  classified  and 
tabulated  so  as  to  yield  useful  information  to  the  manager? 

What  features  may  appropriately  be  included  in  an  analysis 
of  sales? 

In  what  ways  may  error,  whether  arising  thru  mistake  or  thru 

i  The  Library  of  Business  Practice — Volume  IX,  p.  59. 


AUXILIARY  STATEMENTS  47 


inadvertence,  or   thru  intention  to  deceive,  reveal  itself  in  the 
financial  stateme 
For  what  sho 
of  his  business? 


financial  statements? 

For  what  should  the  executive  look  in  a  financial  statement 


CHAPTER  IV 

ANALYSIS  AND  INTERPRETATION  OF  INCOME 

STATEMENTS 

1.  General  divisions  of  the  income  statement. — The 
income  or  revenue  of  a  business  undertaking  is  de- 
rived from  the  sales  of  its  product  or  service,  or  from 
property  which  it  owns.  The  income  may  be  broadly 
classified  as  between  primary  income,  sometimes  called 
operating  revenue,  and  secondary  income,  or  non-op- 
erating revenue.  The  former  represents  income  de- 
rived from  the  principal  business  in  which  the  firm  is 
engaged,  while  the  latter  consists  of  the  income  de- 
rived from  the  capital  or  property  of  the  undertaking 
invested  in  outside  ventures  or  controlled  by  others, 
such  as  interest  on  bonds  or  money  loaned ;  dividends 
on  securities;  rents,  sales  of  by-products  or  sales  of 
scrap  material,  and  so  on. 

As  the  reader  has  already  noted,  the  expense  of  con- 
ducting the  business  includes  the  cost  of  materials 
consumed  in  producing  the  commodities  or  service 
which  the  undertaking  offers  for  sale,  together  with 
the  expenses  incurred  in  selling  the  commodities  or 
service,  and  the  expenses  of  administration.  The  cost 
and  expenses  are  also  classified  as  between  operating 

48 


ANALYSIS  OF  INCOME  STATEMENTS         49 

expenses  and  non-operating  expenses.  Operating  ex- 
penses comprise  the  total  cost  and  expense  of  securing 
the  primary  income  or  the  operating  revenues.  Non- 
operating  expenses  may  be  the  cost  of  securing  non- 
operating  revenue  and  the  cost  of  collecting  it,  or  they 
may  be  expenses  purely  in  connection  with  capital  in- 
vested in  other  activities  than  those  in  which  the  busi- 
ness is  principally  engaged.  For  the  purpose  of  il- 
lustrating the  method  to  be  employed  in  analyzing  and 
interpreting  the  income  account  or  statement  of  an 
undertaking,  a  typical  income  account  of  a  manu- 
facturing organization  has  been  selected.  The  prin- 
ciples applied  are  equally  applicable  to  a  trading  con- 
cern, or  to  any  other  form  of  business  organization. 

2.  Gross  sales  or  gross  income. — All  goods  sold, 
whether  for  cash  or  credit  during  the  period  un- 
der consideration,  will  be  credited  to  the  sales  account. 
This  account  should  be  credited  with  all  valid  sales 
which  legally  transfer  to  the  purchaser  the  title  to 
the  merchandise  disposed  of.  Sales  made  "on  ap- 
proval or  return,"  or  consignments  shipped,  should 
not  be  included  as  regular  sales. 

The  sales  records  should  disclose  the  amount  of  cash 
sales  and  sales  on  credit.  This  information  will  be 
valuable  when  considering  the  relation  between  the 
outstanding  accounts  and  the  total  charge  sales  of  the 
period.  For  example,  if  the  annual  sales  on  credit 
amounted  to  one  million  dollars,  and  if  the  sales  for 
the  different  months  were  uniform,  one  would  next 
consider  what  terms  of  credit  are  usually  allowed. 


50     FINANCIAL  AND  BUSINESS  STATEMENTS 

Let  us  assume  that  the  average  term  of  credit  allowed 
is  thirty  days,  and  that  the  balance  sheet  dis- 
closes $200,000  standing  at  the  debit  of  trade  debtors. 
The  natural  inference  would  be  that  either  lax  collec- 
tion methods  were  being  employed,  or  else  that  the 
amount  standing  at  the  debit  of  trade  debtors  in- 
cluded bad,  doubtful  and  uncollectable  accounts.  In 
ordinary  times  there  will  always  be  a  fair  proportion 
of  customers  discounting  bills,  so  that  while  the  goods 
may  be  sold  on  an  average  term  of  credit  of  thirty 
days,  the  aggregate  of  customers'  outstanding  ac- 
counts should  be  less  than  the  amount  of  two  months' 
sales. 

3.  Goods  on  sale  or  return, — If  goods  have  been 
shipped  to  customers  "on  sale  or  return,"  or  "on  ap- 
proval," and  have  been  credited  to  sales  account  and 
debited  to  trade  debtors,  the  amount  should  be  de- 
ducted from  the  sales  as  well  as  from  trade  debtors. 
The  value  of  the  merchandise  in  the  hands  of  others 
should  be  shown  as  a  part  of  the  inventory.  There 
should  also  be  deducted,  if  necessary,  a  sufficient  sum 
to  take  care  of  the  depreciation  of  the  goods  while  in 
the  hands  of  others,  waiting  to  be  sold,  and  whatever 
sum  it  may  be  necessary  to  deduct  because  of  shop- 
worn condition  of  goods,  and  so  on. 

4.  Trade  discount  on  sales. — When  it  is  custom- 
ary to  allow  trade  discounts,  a  separate  account  may 
be  kept  for  them.  In  this  event,  the  credit  to  gross 
sales  will  be  the  gross  price  with  an  offset  appearing 
in  an  account  under  the  caption  of  "trade  discount  on 


ANALYSIS  OF  INCOME  STATEMENTS         51 

sales."  It  is  sometimes  urged  that  an  account  should 
be  kept  for  the  amount  of  the  trade  discount  allowed 
on  sales  on  the  theory  that  such  an  account  meas- 
ures, to  a  certain  extent,  the  efficiency  of  the  sales 
manager.  The  sales  manager  who  is  able  to  keep  up 
volume  of  sales  with  the  smallest  amount  of  trade 
discounts  is  naturally  the  most  efficient  sales  manager. 
The  author  believes  that  this  contention  is  of  very  little 
practical  weight,  and  doubts  the  advisability  of  keep- 
ing this  information,  by  reason  of  the  time  and  labor 
necessary  to  do  so. 

5.  Price  corrections. — Any  adjustments  that  must 
be  made  because  of  errors  in  invoicing  goods  or  billing 
out  at  erroneous  prices  should  be  corrected  by  debiting 
or  crediting  the  sales  account,  and  crediting  or  debit- 
ing the  account  of  the  customer  according  to  the  char- 
acter of  the  error.  The  correction  of  mathematical 
errors  is  to  be  distinguished  from  allowances  made  to 
customers  because  of  claims  for  damages,  or  short 
weight,  and  the  like.  When  a  customer  has  received 
an  allowance  or  a  price  concession  of  this  nature,  the 
amount  should  be  debited  to  a  sales  allowance  account. 
This  is  for  the  purpose  of  establishing  a  better  con- 
trol over  allowances  of  this  character  which  would 
otherwise  be  lost  sight  of  if  merged  with  the  gross 
sales. 

6.  Sales  returns. — In  some  lines  of  business,  the 
item  of  sales  returns  is  an  important  one.  Business 
men  everywhere  are  trying  to  minimize  this  evil.  In 
order  that  control  may  be  established  over  items  of 


52     FINANCIAL  AND  BUSINESS  STATEMENTS 

this  character  so  that  the  management  may  know  at 
the  end  of  the  period  what  the  relation  is  between  sales 
and  returns,  all  goods  returned  by  customers  should 
be  debited  to  a  sales  returns  account,  and  not  to  the 
gross  sales  account.  It  will  thus  be  possible,  at  the 
end  of  the  fiscal  period,  to  determine  just  what  pro- 
portion of  sales  are  returned,  and  whether  the  evil  is 
increasing  or  decreasing.  A  further  analysis  may 
be  made  to  determine  the  amount  of  returns  in  each 
salesman's  territory,  as  some  salesmen  will  oversell 
their  trade. 

7.  Prepaid  charges  treated  as  sales, — Business 
houses  in  some  cases  are  accustomed  to  prepay 
freight,  insurance  and  cartage,  for  the  accommoda- 
tion of  customers,  charging  the  amounts  of  these 
items  in  the  invoice  with  the  goods  shipped.  In  many 
instances,  these  charges  to  customers  are  credited  in 
their  entirety  to  the  sales  account.  This  is  bad  prac- 
tice, because  it  overstates  the  amount  of  the  sales. 
The  amounts  charged  to  a  customer  for  freight,  in- 
surance and  cartage  prepaid  should  be  offset  against 
the  expense  of  the  shipper  in  that  connection.  The 
sales  account  should  not  be  credited  with  these 
amounts. 

8.  Sales  of  scrap  or  residuals. — Sales  of  scrap  ma- 
terial, or  of  by-products,  should  not  be  credited  to  the 
regular  account,  but  should  be  handled  thru  special 
accounts  created  for  them.  Against  the  income  re- 
ceived from  the  sales  of  scrap  or  residuals  should  be 
offset  the  cost  thereof,  and  the  net  profit  from  the 


ANALYSIS  OF  INCOME  STATEMENTS         53 

transactions  should  be  taken  into  the  income  account 
as  an  item  of  miscellaneous  income. 

As  has  already  been  pointed  out  in  the  Text  on 
"Accounting  Practice,"  sales  to  branches,  or  transfers 
of  merchandise  between  departments,  should  not  be 
included  in  the  sales  account.  The  reader  is  referred 
to  that  volume  for  the  detailed  treatment  to  be  given 
to  transactions  of  this  nature. 

9.  Percentage  calculations. — The  gross  sales,  there- 
fore, as  reduced  by  the  amount  of  returns  and  allow- 
ances, constitute  net  sales.  This  is  the  amount  which 
should  be  used  as  the  base  for  all  percentage  calcula- 
tions that  are  made  on  the  basis  of  selling  price.  In 
this  connection,  it  is  pertinent  to  say  that  while  prob- 
ably the  majority  of  business  undertakings  make  the 
percentage  calculations  in  the  income  account  by  using 
net  sales  as  a  basis,  it  is  mathematically  more  correct 
to  use  the  cost  of  goods  sold  or  the  cost  of  service  ren- 
dered as  a  basis.  One  method  is  just  as  good  as  the 
other,  as  long  as  it  is  borne  in  mind  that  whatever 
basis  is  used,  it  must  be  consistently  employed  thruout. 
One  must  understand  thoroly,  however,  whether  the 
basis  is  cost  of  sales  or  selling  price. 

The  reader  may  have  noticed  literature  that  ap- 
peared from  time  to  time  on  the  subject  of  percentage 
of  profits,  some  authors  insisting  that  but  one  of  the 
methods  of  figuring  the  percentage  of  profit  is  correct, 
and  others  taking  the  opposing  view.  The  impor- 
tant point  that  many  authors  overlook  is  that  when 
the  selling  price  is  taken  as  the  base,  the  base  will  vary 


54     FINANCIAL  AND  BUSINESS  STATEMENTS 

with  the  profits,  since  the  latter  are  included  in  it. 
Yet  it  is  recognized  that  the  chief  reason  for  making 
comparisons  by  means  of  percentages  is  to  reduce 
the  results  to  a  common  base. 

To  quote  from  Dawson's  Compendium : * 

This  variation  is,  moreover,  uncontrolled  by  any  principle, 
being,  in  the  case  of  a  large  proportion  of  profit,  entirely 
disproportionate  to  the  variation  caused  by  a  smaller  rate 
of  profit.  As  an  instance,  10  per  cent  of  profit  computed 
upon  the  cost  price  is  equal  to  9%i  per  cent  when  the  same 
result  is  taken  on  the  selling  price,  but  if  50  per  cent  of  profit 
on  cost  prices  be  computed  upon  selling  prices  it  will  only 
show  331/3  per  cent.  Furthermore,  as  the  sale  price  is  com- 
posed of  the  cost  price  and  the  profit,  the  latter  cannot  ex- 
ceed the  sale  price,  from  which  it  follows  that  a  profit  based 
upon  selling  prices  cannot  exceed  100  per  cent,  nor  even 
equal  100  per  cent,  if  the  goods  have  cost  anything  at  all. 
None  of  these  impurities  or  limitations  exist  in  connection 
with  a  cost  price  percentage.  Of  course,  a  given  percentage 
computed  upon  the  cost  will  always  show  a  certain  other 
percentage  if  the  same  result  as  regards  profits  is  computed 
upon  selling  prices,  i.e.,  10  per  cent  based  upon  cost  is  at 
all  times  equivalent  to  9Mi  per  cent  of  the  selling  price: 
50  per  cent  of  cost  is  always  equal  to  33%  per  cent  of  sale 
price,  and  so  on :  Therefore,  so  long  as  the  rate  of  profit 
is  under  25  per  cent,  and  does  not  vary  greatly,  comparisons 
of  results  based  on  selling  prices  will  not  be  as  misleading  as 
they  would  be  otherwise,  and  may  be  adopted  without  great 
danger,  provided  the  nature  of  the  base  upon  which  they 
are  computed  is  always  borne  in  mind.  It  is  often  urged 
that  a  sale  price  percentage  is  adopted  on  the  score  of  con- 
venience, the  cost  of  the  articles  being  difficult  to  ascertain 
on  account  of  the  difference  of  stocks  and  other  obscuring 
elements.  But  the  cost  incurred  in  respect  of  the  sales  ef- 
fected can  be  obtained  by  a  simple  expedient  as  soon  as  the 

1  The  Accountant's  Compendium  by  S.  S.  Dawson,  p.  466. 


ANALYSIS  OF  INCOME  STATEMENTS         55 

amount  of  profit  has  been  ascertained.  As  above  stated,  the 
cost  and  profit  combined  equal  the  selling  price — therefore, 
if  the  amount  of  profit  be  deducted  from  the  net  sales,  the 
cost  of  the  goods  sold  must  be  the  result,  quite  independently 
of  the  questions  of  purchases,  differences  of  stocks,  etc. 

The  following  extract  will  show  that  the  cost  price  per- 
centage is  not  only  the  true  basis  mathematically,  but  is 
also  in  accord  with  economic  principles : — "The  capitalist, 
then,  may  be  assumed  to  make  all  the  advances  and  receive 
all  the  produce.  His  profit  consists  of  the  excess  of  the 
produce  over  the  advances  ;  his  rate  of  profit  is  the  rate  which 
that  excess  bears  to  the  amount  advanced."  (John  Stuart 
Mill.) 

10.  Outward  freight  and  cartage. — The  question  as 
to  whether  outward  freight  and  cartage  paid  by  a  firm 
for  goods  sold  F.  O.  B.  destination  should  be  deducted 
from  the  selling  price  or  treated  as  a  selling  expense, 
is  the  cause  of  considerable  discussion.  It  would  seem 
that  if  the  general  custom  of  the  concern  in  question 
is  to  deliver  goods  F.  O.  B.  destination,  the  amount 
may  be  very  well  treated  as  an  offset  to  the  net  sales 
in  this  section  of  the  income  account.  When,  how- 
ever, the  allowances  are  not  the  general  custom,  but 
are  under  the  direct  control  of  the  sales  manager,  it 
is  better  to  treat  the  amounts  paid  for  freight  and 
cartage  on  shipments  of  goods  to  customers  as  a  sell- 
ing expense. 

11.  Service  liabilities. — In  certain  enterprises  it  is 
customary  for  the  service  or  merchandise  to  be  paid 
for  in  advance.  Thus,  a  gas  company  supplying  gas 
to  so-called  "prepayment  meters,"  or  a  restaurant  or 
a  railroad  selling  commutation  tickets,  will  always 


56     FINANCIAL  AND  BUSINESS  STATEMENTS 

have  a  greater  amount  of  revenue  received  for  serv- 
ice or  for  merchandise  than  has  actually  been  deliv- 
ered to  the  customers.  Therefore,  all  income  or  rev- 
enue received  from  this  source  may  not  necessarily  be 
income  of  the  present  period.  It  will  be  necessary 
to  determine  by  some  fair  and  adequate  means,  what 
proportion  of  this  revenue  is  to  be  credited  to  the 
current  income  account,  and  what  portion  is  to  be 
set  up  as  a  deferred  credit  to  income  or  deferred  lia- 
bility, representing  the  service  liability  to  be  delivered 
in  the  succeeding  period. 

12.  Instalment  sales. — When  firms  do  business  on 
the  instalment  plan,  the  sales  account  should  be  in- 
terpreted in  the  light  of  the  practices  of  the  firm,  with 
reference  to  the  provisions  set  aside  for  the  loss  on 
doubtful  accounts  and  collection  expenses  in  connec- 
tion therewith.  It  is  also  important  to  note  that  the 
income  account  of  the  period  under  review  has  not 
been  credited  with  a  greater  amount  in  respect  of 
such  sales  than  may  be  properly  taken  to  the  credit 
of  income. 

13.  Containers  included  in  sales  jwices. — Care  must 
be  used  to  see  that  the  sales  account  does  not  receive 
credit  for  containers  charged.  Thus,  in  sales  of  cer- 
tain chemicals,  such  as  anhydrous  ammonia,  con- 
tainers are  charged  with  the  merchandise  to  customers 
in  the  invoice.  It  is  evident  that  the  sales  account 
should  not  receive  credit  for  charges  for  returnable 
containers.  A  special  reserve  account  should  be 
opened  for  such  credits  and  when,  from  time  to  time, 


ANALYSIS  OF  INCOME  STATEMENTS         57 

containers  are  returned,  the  reserve  account  should  be 
debited  for  the  amount  paid  out  in  cash  or  credited 
to  the  account  of  the  customer.  When  the  reserve 
is  large,  it  is  advisable  to  create  a  special  fund  for 
it  to  the  extent  of  the  debits  to  customers  in  respect 
thereof,  collected  in  cash. 

14.  Other  items  of  miscellaneous  income, — Oc- 
casionally, extraordinary  profits  result  from  the  sale 
of  land  holdings,  patents  which  are  of  no  further  use 
to  the  enterprise,  or  other  assets  of  which  it  may  seem 
advisable  to  dispose.  Such  unusual  profits  should 
not  be  merged  with  the  profits  from  business  opera- 
tion, because  to  do  so  would  throw  the  operating 
revenues  out  of  proportion  and  destroy  the  possibility 
of  comparison.  The  proper  practice  is  to  state  such 
items  separately,  under  descriptive  headings,  and  to 
carry  them  as  miscellaneous  income.  Sometimes 
these  items  are  of  such  an  unusual  nature  as  to  con- 
stitute a  direct  addition  to  surplus  and  should  not 
appear  in  the  income  statement  at  all. 

15.  Comparisons  of  sales  with  the  amount  of  the 
final  inventory. — In  order  to  determine  the  efficiency 
of  the  management,  it  is  well  to  make  a  comparison 
between  the  total  volume  of  the  sales  and  the  amount 
of  the  final  inventory.  In  making  this  comparison, 
however,  consideration  must  be  given  to  the  length  of 
time  it  takes  to  manufacture  the  goods.  For  ex- 
ample, if  a  concern  has  annual  sales  amounting  to 
$1,200,000,  and  reports  an  inventory  on  hand  at  the 
end  of  the  period  amounting  to  $500,000,  the  indica- 


58     FINANCIAL  AND  BUSINESS  STATEMENTS 

tions  on  the  surface  are  that  the  firm  is  carrying  too 
much  of  an  investment  in  stock  in  trade.  This  might 
appear  all  the  more  probable  if  it  were  known  that  the 
manufacturing  process  took  approximately  twenty 
days.  The  presence  of  this  large  inventory  would 
indicate  poor  management  in  allowing  stock  to  ac- 
cumulate, or  the  presence  of  a  large  amount  of  dead 
stock,  or  an  inflation  of  inventory  values. 

If  the  gross  profit  on  trading  operations  were  ap- 
proximately the  same  in  the  period  under  considera- 
tion as  in  preceding  periods,  the  question  of  the  in- 
flation of  the  inventory  could  be  dismissed.  Possi- 
bly, a  quantity  of  dead  stock,  and  goods  out  of  style  or 
fashion,  may  be  included  in  the  inventory  at  cost 
prices,  or  it  may  be  that  the  firm  has  overestimated 
its  requirements  in  the  way  of  raw  material,  or  may 
have  manufactured  too  heavily,  and  thus  has  too  much 
of  its  liquid  capital  invested  in  merchandise. 

It  is  not  safe  to  draw  conclusions  without  a  further 
investigation  of  the  facts,  for  it  may  happen  that  a 
large  proportion  of  the  inventory  is  in  raw  materials 
which  the  concern  has  accumulated  at  advantageous 
prices  for  use  in  later  periods.  In  other  instances, 
business  organizations  accumulate  stocks  of  raw  ma- 
terials in  excess  of  their  own  requirements  at  ad- 
vantageous prices,  which  enable  them  to  sell  some  of 
the  raw  material  to  other  less  fortunate  manufac- 
turers. 

The  purchasing  agent  of  one  of  the  large  public 
service  corporations  at  the  beginning  of  the  Euro- 


ANALYSIS  OF  INCOME  STATEMENTS         59 

pean  war  purchased  immense  quantities  of  raw  cop- 
per at  prices  varying  from  14  to  18  cents  a  pound. 
A  large  part  of  the  copper  was  subsequently  sold  to 
other  manufacturers  who  had  not  anticipated  their 
requirements,  at  prices  substantially  over  cost.  How- 
ever, the  comparison  between  the  total  sales  and  the 
final  inventory  ought  to  be  made.  In  the  light  of 
other  information  one  may  judge  whether  or  not 
the  management  is  efficiently  employing  its  liquid 
capital. 

16.  Distinction  between  cost  and  expense. — While 
all  capital  or  value  consumed  in  business  operations 
is  technically  expense,  the  material  and  labor  that 
enter  into  the  manufacture  of  a  product  are  usually 
known  not  as  expenses,  but  as  costs.  General  out- 
lays in  a  factory,  other  than  material  and  labor,  while 
commonly  known  as  factory  or  overhead  expenses, 
are  also  a  part  of  costs.  The  selling  and  adminis- 
trative expenses  form  the  technical  expenses  of  a 
business. 

This  distinction  between  cost  and  expense  is  not 
very  clearly  defined,  and  frequently  the  two  terms  are 
used  synonymously.  The  distinction  is  one  of  con- 
venience rather  than  of  necessity.  The  details  of  cost 
accounts  have  been  covered  in  the  Text  on  "Cost 
Finding."  We  are  interested  in  them  only  in  so  far 
as  they  affect  the  preparation  and  interpretation  of 
financial  statements. 

17.  Distinction  between  expenditures  and  disburse- 
ments.— Business  men  in  their  dealings  quite  nat- 

XXII— 6 


60    FINANCIAL  AND  BUSINESS  STATEMENTS 

urally  come  to  regard  every  transaction  from  a  cash 
standpoint.  Income  from  this  point  of  view  is  held 
to  mean  the  receipt  of  so  much  cash,  and  expense  is 
not  considered  an  expense  until  the  money  is  actually 
paid  over.  True  enough,  all  revenue,  if  collected,  will 
ultimately  be  realized  in  the  form  of  cash  and  all  ex- 
penses will  ultimately  be  paid  in  cash.  But  there  is 
a  fallacy  in  considering  that  at  any  particular  instant 
of  time,  a  business  is  entirely  on  a  cash  basis.  Ma- 
terial may  be  received  and  consumed  long  before  it 
is  paid  for,  and  it  is  often  paid  for  long  before  it  is 
received.  On  the  other  hand,  sales  may  be  made 
which  will  not  bring  in  any  cash  for  some  time. 
Therefore  expenses  and  disbursements  do  not  neces- 
sarily synchronize. 

18.  Elements  of  cost. — The  first  element  in  the 
cost  of  the  goods  sold  or  in  the  operating  expenses  is 
the  cost  of  the  material  consumed.  This  is  found  by 
adding  to  the  inventory  at  the  beginning  of  the  pe- 
riod, the  purchases  during  the  period,  and  deducting 
from  the  aggregate,  the  amount  of  the  raw  material 
on  hand  at  the  end  of  it. 

All  transportation  charges  incurred  in  delivering 
materials  and  supplies  upon  the  premises  are  part 
of  the  cost  of  such  materials.  The  expense  of  the 
purchasing  department  is  often  distributed  over  the 
purchases  made,  a  rateable  portion  being  assigned  to 
the  materials  consumed,  and  the  balance  to  the  in- 
ventory on  hand  at  the  end  of  the  period  and  is  thus 
carried  as  a  part  of  the  inventory  value  of  raw  ma- 


ANALYSIS  OF  INCOME  STATEMENTS         61 

terials.  If  an  inspection  department  is  maintained 
for  the  purpose  of  making  tests  of  the  quality  of 
the  material  received,  the  expense  of  this  department, 
as  well  as  the  expense  of  the  receiving  department, 
form  an  additional  element  in  the  cost  of  the  material 
consumed.  In  other  organizations  it  is  customary  to 
pass  the  raw  material  thru  a  store  room,  and  in  this 
event,  a  rateable  proportion  of  the  expense  of  operat- 
ing the  storeroom  is  assignable  to  each  unit  of  mer- 
chandise. 

In  practice  it  will  usually  be  difficult  to  definitely 
assign  to  each  unit  of  materials  or  supplies  consumed, 
a  rateable  proportion  of  the  expense  of  operating  the 
purchasing,  inspection,  receiving  and  storeroom  de- 
partments. In  many  cases,  the  entire  cost  of  operat- 
ing these  departments  during  the  period  is  charged 
as  an  expense  of  the  current  period.  When  this  ex- 
pense is  fairly  uniform  from  period  to  period,  there  is 
probably  no  great  error  in  following  this  practice,  as 
it  would  not  make  any  difference  after  the  initial  pe- 
riod. 

19.  Treatment  of  cash  discounts  on  purchases. — 
Invoices  for  purchases  are  frequently  subject  to  a 
special  discount  for  prompt  payment  in  cash.  The 
question  will  arise  as  to  whether  the  deductions  made 
on  the  payment  of  invoices  are  to  be  applied  to  the 
credit  of  the  materials  purchased  or  are  to  be  treated 
as  secondary  income.  In  favor  of  the  first  theory, 
it  is  urged  that  cost  means  the  net  cost  to  the  pur- 
chaser, and  therefore,  the  cost  of  raw  materials,  as 


62     FINANCIAL  AND  BUSINESS  STATEMENTS 

shown  in  the  operating  expense  account,  should  be 
the  cost  less  the  cash  discount  received. 

On  the  other  hand,  it  is  contended  that  the  ability 
to  take  advantage  of  cash  discounts  arises  solely  from 
the  power  of  the  organization  to  command  the  capital 
necessary  to  enable  it  to  do  so.  In  fact,  it  may  pay 
in  many  instances  to  borrow  the  funds  necessary  to 
discount  bills  promptly.  Indeed  in  certain  lines  of 
business,  the  profits  obtained  from  the  discounting  of 
bills  is  greater  than  the  profit  on  the  sale  of  the  mer- 
chandise. If  a  firm  could  not  borrow  the  money  with 
which  to  discount  bills,  or  if  it  did  not  have  a  suffi- 
cient amount  of  owned  capital,  it  could  not  secure 
this  advantage.  The  advantage  is  therefore  one 
which  arises  solely  because  of  the  presence  of  a  suffi- 
cient amount  of  capital,  either  owned  or  borrowed. 
If  money  has  been  borrowed  for  this  purpose,  the 
cost  of  the  borrowed  funds  will  appear  as  a  deduction 
from  income,  or  as  a  non-operating  expense.  It  fol- 
lows then,  that  the  saving  made  in  discounting  bills 
with  borrowed  funds  ought  logically  to  appear  as  non- 
operating  income,  or  as  other  income.  The  author 
favors  the  second  method  of  treatment. 

20.  Labor. — Labor  is  the  cost  of  the  human  serv- 
ice rendered  in  manufacturing  the  goods,  or  in  pro- 
ducing the  service  rendered  by  the  undertaking.  The 
amount  charged  for  labor  should  include  not  only  the 
sums  actually  expended  in  cash,  but  also  the  amount 
of  labor  service  rendered  which  may  not  have  been 
paid  for  at  the  date  of  the  accounting. 


ANALYSIS  OF  INCOME  STATEMENTS         63 

21.  Heat,  light  and  power. — The  cost  of  fuel  used 
in  developing  the  heat,  light  and  power,  including 
freight  paid  on  the  coal,  the  unloading  charges 
thereof,  and  the  cost  of  bringing  the  fuel  to  the  point 
at  which  it  is  to  be  used,  figure  in  the  heat,  light  and 
power  account.  In  a  large  manufacturing  establish- 
ment, there  is  usually  employed  a  gang  of  day  la- 
borers, sometimes  known  as  roustabouts,  who  are  en- 
gaged in  various  odd  duties,  among  which  is  that  of 
hauling  the  coal  from  the  storage  pile  to  the  stokers 
or  to  the  boiler  room.  The  amount  of  labor  devoted 
to  this  purpose  is  to  be  charged  to  the  fuel  account. 
All  water  used  for  feed  water  should  also  be  charged 
to  this  account.  A  rateable  proportion  of  the  engi- 
neer's services  expended  in  the  supervision  of  the 
boiler  room  should  figure  in  this  account  and  this  is 
obviously  true  of  the  wages  of  firemen,  tenders  and 
oilers. 

Many  firms  keep  a  heat,  light  and  power  account 
as  a  clearing  account,  and  distribute  it  upon  some 
equitable  basis  at  the  end  of  the  accounting  period 
over  the  departments  which  have  received  the  benefit 
from  it.  Thus,  for  example,  if  live  steam  is  fur- 
nished to  any  department,  it  is  possible  to  instal  flow 
meters  to  determine  the  amount  delivered  as  a  basis 
for  the  charge.  The  various  departments  will  be 
charged  for  light  on  the  basis  of  candle  power  used 
in  the  respective  departments.  Heat  will  be  charged 
for  on  the  basis  of  the  radiation  surface.  In  this 
I  manner  an  attempt  will  be  made  to  distribute  the  en- 


64     FINANCIAL  AND  BUSINESS  STATEMENTS 

tire  amount  charged  to  heat,  light  and  power  to  the 
various  departments  which  have  received  the  bene- 
fits of  these  services. 

Other  elements  of  overhead  expenses  have  been 
fully  explained  in  the  Text  on  "Cost  Finding,"  there- 
fore no  detailed  analysis  is  given  here. 

22.  Cost  of  manufacture  and  cost  of  sales  dis- 
tinguished,— The  difference  between  the  cost  of  goods 
manufactured  and  the  cost  of  goods  sold  should,  how- 
ever, be  pointed  out.  In  arriving  at  the  cost  of  goods 
manufactured,  we  start  out  with  the  initial  inventory 
of  raw  material  and  work  in  process,  and  add  to  the 
aggregate  of  these  amounts,  the  total  purchases,  la- 
bor and  factory  expenses  incurred  during  the  period. 
From  this  aggregate  we  deduct  the  amount  of  the 
inventory  of  raw  materials  and  work  in  process  at 
the  end  of  the  accounting  period.  The  resultant  is 
the  cost  of  goods  manufactured. 

The  cost  of  goods  sold  during  the  period,  is  found 
by  applying  to  the  cost  of  goods  manufactured,  the 
difference  between  the  inventories  of  finished  goods 
at  the  beginning  and  at  the  end  of  the  period.  Start- 
ing with  the  inventory  of  finished  goods  on  hand  at 
the  beginning  of  the  period,  we  add  the  cost  of  the 
goods  manufactured  during  the  period,  and  deduct  the 
value  of  the  finished  goods  on  hand  at  the  end 
of  the  period.  The  resultant  will  be  the  cost 
of  goods  sold.  Or,  to  express  it  in  another  way,  to 
find  the  cost  of  the  goods  sold,  take  the  total  pur- 
chases and  add  to  them  the  labor  expended  and  the 


ANALYSIS  OF  INCOME  STATEMENTS         65 

factory  expenses  during  the  period,  and  adjust  the 
aggregate  by  the  difference  between  the  initial  and 
final  inventories  of  raw  materials,  work  in  process  and 
finished  goods,  adding  to  the  aggregate  found  above, 
all  decreases  in  inventory  and  deducting  all  increases 
in  inventory. 

23.  Percentage  calculations  must  be  made  on  cor- 
rect basis. — The  difference  between  the  income  from 
sales  and  the  cost  of  the  goods  sold  is  the  gross  profit 
on  sales.     As  already  shown,  the  percentage  of  gross 
profits  on  sales  may  be  calculated  by  using  as  a  basis 
either  the  cost  of  goods  sold  or  the  income  from  sales. 
The  reader  has  already  been  warned  in  a  preceding 
chapter,  that  percentage  calculations  generally  should 
be  made  with  care.     Percentage  calculations  should 
not  be  made  unless  the  conditions  are  such  as  admit 
of  correct  averages  being  taken.     As  a  concrete  illus- 
tration, in  the  distribution  of  overhead  expense  on  the 
monthly  basis,  inasmuch  as  the  base  upon  which  the 
calculation  is  made  will  vary  from  month  to  month, 
the  percentage  distributions  will  do  likewise.     If  a 
calculation  is  made  upon  the  aggregates  of  a  quarter, 
different  rates  of  percentage  will  be  obtained  than  if 
the  calculations  were  made  monthly.     This  is  true  be- 
cause the  basic  facts  in  each  of  these  cases  are  differ- 
ent.    Hence,  care  must  be  used  in  making  percentage 
calculations  to  see  that  the  facts  prepared  on  the  per- 
centage basis  are  capable  of  accurate  comparison  on 
that  basis.     When  the  percentage  of  gross  profit  has 
been  ascertained,  by  whatever  basis  it  may  be  cal- 


66     FINANCIAL  AND  BUSINESS  STATEMENTS 

culated,  the  cause  of  any  increase  or  decrease  should 
be  inquired  into. 

24.  Calculation  of  the  turnover, — The  turnover 
of  capital  invested  in  stock  in  trade  is  calculated  by 
dividing  the  cost  of  the  goods  sold  either  by  the  initial 
inventory  or  by  the  average  inventory  for  the  year. 
Starting  with  the  initial  inventory,  we  add  to  it  the 
purchases  in  a  trading  concern  or  the  cost  of  manu- 
factured goods  in  a  manufacturing  business,  and  de- 
duct from  the  aggregate  so  found  the  inventory  of 
goods  on  hand  at  the  end  of  the  period.  It  will  be 
seen  that  this  resultant  is  the  material  cost  of  the  goods 
sold  during  the  period.  Divide  the  cost  of  the  goods 
sold  either  by  the  initial  inventory  or  by  the  average 
monthly  inventory  and  the  resultant  will  be  the  turn- 
over, or  the  number  of  times  which  the  capital  in- 
vested in  goods  has  been  turned  over  during  the  pe- 
riod. Where  the  monthly  inventories  fluctuate  or 
where  the  initial  inventory  may  not  be  a  fair  one  to 
use,  it  is  better  to  take  the  average  monthly  inventory 
as  the  divisor. 

The  ability  to  turn  merchandise  quickly  indicates 
good  management.  Manifestly,  a  man  who  can  turn 
his  stock  four  times  in  a  year  has  made  more  on  his 
capital  investment  than  the  man  who  has  been  able 
to  turn  his  stock  only  three  times.  Snap  judgments, 
however,  cannot  be  based  on  the  turnover.  There 
may  be  good  and  valid  reasons  why  the  turnover  is 
reduced,  and  all  the  facts  surrounding  each  individual 
case  must  be  carefully  considered.     A  large  increase 


ANALYSIS  OF  INCOME  STATEMENTS         67 

in  inventories  will  naturally  have  a  tendency  to  re- 
duce the  turnover  but,  on  the  other  hand,  this  might 
be  offset  by  realizing  a  greater  margin  of  profit  on 
the  goods  that  were  sold.  At  any  rate,  a  comparison 
of  the  turnover  with  that  of  preceding  periods,  and 
in  connection  with  the  increase  or  decrease  in  the 
gross  profit  from  sales,  will  prove  interesting. 

There  is,  too,  a  danger  in  attempting  to  increase  the 
turnover  by  reducing  the  amount  of  the  inventory 
carried,  because  in  certain  instances,  the  seller  may 
not  be  able  to  keep  his  stock  complete  at  all  times. 
He  may  lose  sales  thru  not  having  the  goods  on  hand 
at  the  time  that  customers  order  them  because  he 
is  over-anxious  to  keep  the  stock  down  to  the  lowest 
possible  limit.  Delays  are  often  encountered  in  the 
receipt  of  merchandise,  and  a  merchant  who  has  lost 
the  opportunity  to  make  a  sale  because  goods  are 
out  of  stock  has  lost  profits  that  he  may  never  re- 
cover. On  the  other  hand,  laxity  in  this  respect  may 
also  result  in  a  loss,  for  it  is  evident  that  too  great 
an  amount  of  capital  invested  in  goods  on  the  shelves 
may  eat  up  all,  or  a  part  of  the  profits,  thru  interest 
charges.  Past  experience  will  usually  enable  the 
management  to  determine  the  lowest  limit  to  which  it 
may  safely  allow  the  stock  to  be  reduced. 

REVIEW 

What  should  and  what  should  not  figure  in  a  statement  of 
gross   sales?     How  are  net  sales  derived  from  them? 

State  the  arguments  for  basing  the  per  cent  of  profit  upon  the 
cost  price,  and  upon  the  sales  price. 


68     FINANCIAL  AND  BUSINESS  STATEMENTS 

What  deductions  are  drawn  from  a  comparison  of  total  sales 
and  final  inventories?  What  cautions  must  be  observed  in  draw- 
ing conclusions? 

Distinguish  between  cost  and  expense,  expenditures  and  dis- 
bursements. 

Describe  what  enters  into  the  heat,  light  and  power  account, 
and  what  purposes  this  account  serves. 

What  are  the  rules  for  calculating  the  turnover,  and  what  is 
the  importance  of  the  turnover? 


CHAPTER  V 

ANALYSIS  AND  INTERPRETATION  OF  INCOME 
STATEMENTS  (Continued) 

1.  Quantity  discounts  on  purchases. — When  quan- 
tity discounts  on  merchandise  purchases  are  received, 
it  is  advisable  to  record  them  in  a  separate  account 
and  not  to  merge  them  either  with  purchases  or  with 
purchase  allowances.  All  quantity  discounts  that 
have  been  earned  during  the  period  should  be  in- 
cluded in  the  accounts  even  tho  they  have  not  been 
received  in  cash.  If  this  is  not  done,  the  income  ac- 
count in  the  next  period  will  receive  the  benefit  of 
such  rebates  at  the  expense  of  the  preceding  period. 

Separate  accounts  should  also  be  kept  for  raw  ma- 
terial purchases  and  for  finished  parts  purchased.  It 
is  unnecessary  here  to  discuss  more  fully  the  pur- 
chase of  materials  as  between  direct  and  indirect  ma- 
terial, because  these  matters  have  been  treated  in  the 
Text  on  "Cost  Finding."  The  technical  distinction 
between  these  classes  of  material  is  of  little  importance 
to  us  for  present  purposes  except  in  so  far  as  it  affects 
the  comparisons. 

2.  Purchase  returns  and  allowances. — As  in  the 
case  of  sales,  purchase  returns  and  purchase  allow- 

69 


70     FINANCIAL  AND  BUSINESS  STATEMENTS 

ances  should  be  separated.  While  the  information  to 
be  disclosed  from  these  accounts  is  not  so  valuable 
as  that  resulting  from  the  same  practice  when  ap- 
plied to  the  sales,  yet  the  information  is  likely  to 
prove  of  interest.  Furthermore,  no  additional  labor 
is  involved  in  recording  the  information  in  detail. 

3.  Maintenance  charges, — Repairs  and  renewals  of 
factory  equipment,  and  operating  and  depreciation 
charges  in  their  relation  to  the  cost  of  goods  sold,  have 
already  been  fully  discussed  in  the  Text  on  "Cost 
Finding."  The  important  point  to  be  noted  in  this 
connection  is  that  in  a  comparison  of  income  state- 
ments over  a  series  of  years,  the  elements  must  be  care- 
fully compared  to  see  whether  or  not  there  are  any  in- 
creases or  decreases  worthy  of  note.  If  so,  investiga- 
tion should  be  made  to  determine  their  causes. 

4.  Selling  expenses. — All  the  expenses  of  market- 
ing and  of  distributing  the  products  are  included  un- 
der selling  expenses.  Among  the  items  to  be  found  in 
this  group  will  be  the  salaries  of  the  sales  manager  and 
his  assistant,  the  salaries  and  traveling  expenses  of 
the  salesmen,  and  the  commissions  allowed  on  sales 
actually  made.  The  full  amount  of  such  expenses 
as  have  accrued  during  the  period  should  be  charged 
against  the  income  whether  or  not  they  have  been 
liquidated  in  cash.  The  amount  paid  for  the  rent 
of  storerooms  or  warehouses  for  finished  goods  is 
properly  chargeable  to  this  group  of  expenses. 

Advertising  expense  and  promotion  expense  in  de- 
veloping new  business  are  usually  grouped  under  the 


ANALYSIS  OF  INCOME  STATEMENTS         71 

caption  of  advertising.  Included  in  this  amount  will 
be  the  salaries  and  expenses  of  the  advertising  man- 
ager and  his  staff.  The  account  will  also  include  the 
cost  of  printed  catalogs  and  advertising  literature,  to- 
gether with  the  expense  of  advertisements  in  news- 
papers and  magazines.  For  the  balance  sheet  it  is 
usually  considered  proper  to  inventory  at  cost,  the 
amount  of  advertising  literature  on  hand,  and  to  treat 
as  an  inventory,  space  contracted  and  paid  for  in 
advance,  thereby  reducing  the  amount  chargeable  to 
the  expenses  of  the  period  under  review.  The  ques- 
tion as  to  whether  or  not  any  portion  of  the  advertis- 
ing expense  in  connection  with  a  national  advertis- 
ing campaign  should  be  treated  as  an  asset  will  be 
discussed  in  a  later  chapter. 

5.  Rebates  allowed  to  customers. — Let  us  assume 
that  a  sewing  machine  manufacturer  makes  an  al- 
lowance to  a  customer  for  an  old  machine,  agreeing 
to  take  the  machine  at  a  price  considerably  in  excess 
of  its  residual  value,  or  in  excess  of  its  value  for  re- 
building. The  question  arises  as  to  the  disposition 
to  be  made  of  the  difference  between  the  exchange 
price  allowed  to  the  customer  for  the  old  machine 
and  its  residual  value,  or  the  value  for  rebuilding  pur- 
poses. Should  this  be  treated  as  a  deduction  from 
the  net  sales,  or  as  a  selling  expense?  It  is  usual  to 
allow  the  sales  manager  an  appropriation  each  year 
for  this  purpose,  within  which  he  must  work.  Inas- 
much, therefore,  as  the  item  is  one  under  the  direct 
control  of  the  sales  manager,  it  seems  proper  to  charge 


72    FINANCIAL  AND  BUSINESS  STATEMENTS 

to  selling  expenses  the  loss  sustained  on  amounts  al- 
lowed to  customers  on  exchanges. 

Moreover,  there  is  an  element  of  advertising  in  the 
transaction,  because  when  Mrs.  Smith  shows  her  New 
Era  sewing  machine  to  her  neighbor,  Mrs.  Jones,  the 
latter  will  probably  decide  that  she  will  have  to  buy 
a  new  machine  also,  and  an  additional  sale  results. 

On  the  other  hand,  when  there  is  no  advertising 
feature  connected  with  the  rebate  allowed  to  a  cus- 
tomer, or  when  the  matter  is  beyond  the  control  and 
jurisdiction  of  the  selling  department,  rebates  may 
be  more  properly  treated  as  a  deduction  from  sales 
before  arriving  at  income  from  sales. 

6.  Other  selling  expenses. — All  devices  for  secur- 
ing trade  are  properly  chargeable  to  this  general 
group  of  selling  expenses.  The  loss  on  restaurants 
in  department  stores  is  frequently  charged  as  adver- 
tising expense ;  the  costs  of  lectures  or  fashion  reviews 
or  daily  concerts  are  charged  to  the  same  account. 
One  department  store  follows  the  practice  of  charg- 
ing the  advertising  account  and  crediting  the  expense 
of  operating  its  stable  and  delivery  department  with  a 
fixed  annual  charge  for  advertising,  because  the  de- 
livery wagons  carry  notices  of  special  sales,  from  time 
to  time. 

7.  Distribution  of  stable  and  delivery  expense. — 
The  stable  and  delivery  expense  is  quite  commonly 
pro-rated  between  incoming  freight  and  outgoing 
freight  upon  a  tonnage  basis,  or  upon  some  other 
equitable   basis.     The   problem   of   distributing   de- 


ANALYSIS  OF  INCOME  STATEMENTS         73 

livery  expense  is  somewhat  complicated,  especially  in 
a  department  store.  The  problem  of  internal  ex- 
pense distribution  is  one  of  cost  finding,  primarily, 
and  needs  no  further  discussion  at  this  point. 

8.  Administrative  expenses. — The  next  group  of 
expenses  are  those  which  have  to  do  with  the  manage- 
ment of  the  enterprise.  They  are  made  up  of  the 
expenses  which  cannot  be  directly  apportioned,  either 
to  manufacturing  or  to  selling  activities.  As  a  mat- 
ter of  fact,  however,  administrative  expenses  are 
usually  for  the  benefit  of  both  the  manufacturing  and 
the  selling  departments.  It  is  of  importance  to  know 
that  the  cost  of  supervising  the  establishment  is  in 
proper  relation  to  the  cost  of  manufacture,  the  sell- 
ing expense  and  the  amount  of  the  sales.  Included  in 
this  group  will  be  the  salaries,  traveling  and  incidental 
expenses  of  the  general  officers  and  of  the  general  of- 
fice clerks ;  office  supplies  and  expenses ;  the  rent  of  ad- 
ministrative offices ;  the  outlay  in  stationery,  printing, 
telephoning,  telegraphing,  cabling;  legal  expenses 
which  cannot  be  properly  provided  for  elsewhere, 
and  those  miscellaneous  and  general  expenses  that 
cannot  be  properly  allocated  to  any  individual  depart- 
ment or  function. 

The  depreciation  of  the  office  furniture  may  also 
be  properly  charged  to  this  group  of  expenses. 

9.  Selling  profit  and  net  profit  from  operation. — 
The  deduction  of  the  selling  expenses  from  the  gross 
profit  on  sales  gives  us  the  selling  profit.  By  de- 
ducting the  administrative  expenses  from  the  selling 


74    FINANCIAL  AND  BUSINESS  STATEMENTS 

profit  we  arrive  at  the  net  profit  on  operations,  or  as 
it  is  sometimes  called,  net  income  from  operation. 
The  three  important  factors  to  bear  in  mind  are :  ( 1 ) 
the  amount  of  the  gross  income  from  sales,  (2)  the 
cost  of  the  sales,  including  administrative  expenses, 
and  (3)  the  net  income  from  sales.  For  the  sake  of 
brevity,  we  will  hereafter  refer  to  these  three  ele- 
ments as  the  gross  income,  the  operating  expense,  and 
the  net  income. 

10.  Effect  on  gross  earnings. — The  gross  earn- 
ings will  immediately  reflect  a  decline  in  prosperity. 
This  is  especially  true  in  the  case  of  a  manufacturing 
or  trading  concern ;  this  decline  is  not  so  marked  in  the 
case  of  a  street  railway  or  public  service  corporation. 
Nevertheless,  railroads  immediately  feel  the  effect  of 
a  business  depression  because  of  the  reduced  vol- 
ume of  freight  earnings  and  the  lessening  pur- 
chasing power  of  the  public.  It  is,  therefore,  of  im- 
portance to  attempt  to  measure  the  probable  effect 
of  business  depression  on  gross  income,  and  also 
to  attempt  to  forecast  the  future  business  outlook. 

11.  Operating  expense  is  not  easy  to  reduce. — 
Operating  expenses  do  not,  as  a  rule,  decline  in  the 
same  ratio  as  gross  income.  This  is  due  to  several 
causes:  first,  wages  are  usually  the  last  thing  to  be 
reduced ;  second,  a  concern  that  has  planned  to  manu- 
facture a  certain  output  and  has  built  up  an  organiza- 
tion for  that  purpose  will  always  have  a  certain 
amount  of  overhead  expense  which  must  be  carried  in 
dull  times  as  well  as  in  prosperous  times;  third,  the 


ANALYSIS  OF  INCOME  STATEMENTS         75 

cost  of  materials,  both  direct  and  indirect,  does  not 
usually  decline  with  the  same  rapidity  as  gross  in- 
come. Therefore,  unless  the  organization  prunes 
very  heavily  the  maintenance  expenses  and  the  allow- 
ances for  depreciation,  the  net  income  is  likely  to  de- 
crease in  a  greater  ratio  than  the  gross  income. 

If  the  organization  in  attempting  to  reduce  its  op- 
erating expenses  and  thereby  increasing  the  net  in- 
come, has  neglected  to  make  necessary  expenditures 
for  maintenance,  repairs  and  renewals,  the  earnings 
of  the  period  will  be  overstated,  and  the  cost  of  mak- 
ing good  the  deferred  maintenance  and  renewal 
charges  will  have  to  be  borne  by  later  periods. 

12.  Interpretation  of  net  income, — From  the  net 
income  the  fixed  charges  of  the  corporation  for  in- 
terest, sinking  fund  requirements,  if  any,  and  divi- 
dends must  be  met.  If  too  great  a  proportion  of  the 
gross  income  is  used  in  operating  expenses  it  is  possi- 
ble that  the  net  income  may  be  insufficient  in  amount 
to  meet  the  fixed  charges  of  the  firm.  Bondholders 
require  the  assurance  that  the  net  income  will  amount 
to  at  least  twice  the  sum  required  to  pay  interest  on 
bonds  and  other  fixed  charges.  Experience  has 
proved  this  proportion  to  be  a  proper  margin  of 
safety. 

In  the  case  of  a  corporation  a  decline  in  net  income 
may  mean  that  stockholders  will  have  their  dividends 
reduced.  If  the  corporation  in  its  prosperous  pe- 
riod, has  set  aside  a  surplus  or  dividend  equalization 
reserve,  the  dividends  may  be  paid  in  part  out  of  sur- 

XXII — 7 


76     FINANCIAL  AND  BUSINESS  STATEMENTS 

plus  created  in  this  way.  The  distribution  of  any 
part  of  this  locked-up  surplus  will  reduce  the  work- 
ing capital  of  the  organization.  It  may  too  have  a 
tendency  to  increase  the  outside  borrowing,  perhaps 
even  to  weaken  the  concern  so  that  it  will  not  be  able 
to  take  advantage  of  market  conditions  in  the  pur- 
chase of  raw  materials,  or  in  discounting  all  of  its  bills. 

The  reader  will  perhaps  now  more  fully  realize  the 
effect  on  the  income  account  if  capital  items  are 
charged  to  the  revenue  account,  or  if  revenue  items 
are  charged  to  capital.  In  the  first  case,  a  dishonest 
board  of  directors  might  "freeze  out"  debenture  bond- 
holders, or  depress  the  price  of  stock  to  the  disad- 
vantage of  the  holders.  In  the  latter  case,  an  appear- 
ance of  apparent  prosperity  might  be  continued  for 
a  number  of  years,  with  the  result  that  after  a  pe- 
riod of  time,  a  drastic  reorganization  and  a  scaling 
down  of  bond  and  stock  issues  become  inevitable. 

Sole  traders  and  members  of  partnerships  are,  of 
course,  equally  as  interested  in  comparison  of  gross 
and  net  income  as  are  members  of  a  corporation. 

13.  Other  income  and  income  charges. — Dividends 
on  stock  owned  or  interest  on  bonds  owned;  inter- 
est on  any  mortgages  receivable;  cash  discount  on 
purchases;  interest  on  notes,  accounts  or  on  bank 
deposits;  rent,  royalties  or  commissions  received 
are  included  in  other  income.  In  fact,  any  item  of 
income  received  other  than  that  from  the  sale  of  the 
product,  or  from  the  service  which  the  organization 
offers  or  renders  for  sale,  would  be  taken  into  this 


ANALYSIS  OF  INCOME  STATEMENTS         77 

section  of  the  income  account.  When  any  expense 
has  been  incurred  directly  in  securing  this  income,  it 
is  customary  to  state  in  the  income  account  the  ex- 
cess of  the  income  over  the  expense  of  securing  it, 
ear-marking  the  item  "net"  in  the  income  account. 

Expense  incurred  for  interest  on  borrowed  funds, 
cash  discounts  allowed  on  sales  of  merchandise,  pay- 
ments of  rent,  insurance,  taxes  or  royalties  would  be 
included  under  income  charges. 

14.  Treatment  of  taxes  and  rent, — There  is  consid- 
erable difference  of  opinion  among  accountants  as  to 
the  character  of  the  items  that  should  be  carried  under 
taxes  and  rent.  Some  authorities  take  the  view  that 
taxes  and  rent  paid  for  a  factory  building  should  be 
charged  as  a  part  of  the  manufacturing  expenses. 
Others  hold  that  since  taxes  are  sums  paid  for  the 
protection  of  invested  capital,  the  amounts  paid  are 
capital  expenses  and  therefore  have  nothing  to  do 
with  operating  expense.  It  may  be  pointed  out  that 
operations  are  conducted  just  as  efficiently  in  owned 
as  in  rented  property.  Moreover,  a  decision  as  to 
whether  or  not  an  organization  shall  own  or  rent  its 
own  plant,  rests  with  the  executives  and  not  with  the 
operating  department.  These  questions  are  matters 
which  each  organization  must  settle  for  itself. 

15.  Cash  discounts  on  sales. — Discounts  which  are 
allowed  to  customers  for  the  prompt  payment  of  their 
accounts  are  also  viewed  from  two  standpoints.  One 
is  that  discounts  are  offsets  against  the  sales  prices 
and  should  be  deducted  before  stating  income  from 


78     FINANCIAL  AND  BUSINESS  STATEMENTS 

sales;  the  other  that  the  transaction  is  a  purely  fi- 
nancial one  and  that  the  allowance  made  for  the 
prompt  payment  of  customers'  accounts  reduces  the 
necessary  borrowing  by  the  firm,  the  risk  of  loss  on 
bad  accounts,  and  collection  expenses. 

16.  Insurance  expense, — Insurance  expense  is  also 
the  subject  of  much  debate.  Those  who  favor  stating 
the  insurance  expense  in  this  section  of  the  income 
account  call  attention  to  the  fact  that  it  is  a  sum  paid 
for  the  protection  of  capital,  and  therefore  a  capital 
expense.  Others  hold  that  this  expense  should  be  al- 
located to  the  individual  operating  functions,  namely 
fire  insurance  on  the  factory  together  with  liability 
insurance  on  employes  should  be  charged  as  one  of 
the  necessary  and  incidental  expenses  of  manufactur- 
ing; the  insurance  paid  on  the  stock  of  raw  materials 
must  be  counted  in  the  cost  of  producing  the  finished 
product,  etc.  On  the  other  hand,  attention  is  called 
to  the  fact  that  insurance  rates  are  totally  out  of  the 
control  of  the  operating  officials.  Moreover,  in  view 
of  the  fact  that  insurance  is  a  contract  of  indemnity 
which  protects  the  capital  investment  of  the  organiza- 
tion, it  is  a  capital  charge  and  should  be  shown  as  a 
deduction  from  income. 

To  the  income  from  operations  will  be  added  the 
amount  of  the  secondary  income  received,  and  from 
this  aggregate  will  be  deducted  the  amount  of  the 
income  charges.  The  resultant  will  be  the  net  in- 
come for  the  period  which  amount  is  subject  to  still 
further  adjustment. 


ANALYSIS  OF  INCOME  STATEMENTS         79 

17.  Profit  and  loss  credits  and  charges. — Items  of 
miscellaneous  income  that  do  not  occur  with  sufficient 
regularity  to  be  shown  under  the  heading  of  other 
income  such  as  miscellaneous  income  or  profits  from 
the  sales  of  assets  or  scrap  material  would  appear  un- 
der profit  and  loss  credits  and  charges. 

On  the  other  hand,  there  would  be  charged  losses 
due  to  bad  debts,  depreciation  provisions  that  could 
not  be  allocated  against  operating  functions,  and  any 
other  item  of  unusual  or  extraordinary  loss  suffered 
during  the  period. 

Extraordinary  income  or  extraordinary  losses 
should  be  apportioned  among  periods;  that  is,  any 
portion  of  income  received  or  any  loss  sustained  which 
does  not  apply  to  the  period  under  review  should  be 
adjusted  thru  the  surplus  or  deficit  account. 

In  analyzing  an  income  account  care  should  be 
taken  to  see  that  the  fixed  charges  are  not  in  excess 
of  the  net  income  from  operation.  Occasionally,  it 
will  happen  that  a  business  organization  has  extraor- 
dinary sources  of  outside  income,  and  in  a  year  in 
which  the  net  income  is  not  sufficient  to  meet  the 
fixed  charges,  the  income  from  outside  sources  will 
be  added  to  the  net  income  from  operations  and  the 
fixed  charges  deducted  from  the  aggregate.  This 
results  in  a  misleading  statement  because  it  attempts 
to  conceal  the  fact  that  the  business  has  not  earned 
enough  net  income  from  operations  to  pay  its  fixed 
charges. 

The  effect  of  the  sinking  fund  reserve  requirements, 


80     FINANCIAL  AND  BUSINESS  STATEMENTS 

as  well  as  other  reserves,  and  their  respective  rela- 
tions to  the  income  account  are  discussed  in  later 
chapters. 

18.  Transfer  of  net  profits. — In  a  corporation  the 
balance  of  net  profit  is  transferred  to  the  surplus  ac- 
count and  remains  as  a  contingent  reserve  or  as  a 
working  capital  of  the  business.  From  the  surplus 
will  be  set  aside  various  reserves.  In  some  cases  divi- 
dend equalization  reserves  are  created,  so  that  if  in 
any  year,  the  profits  from  operation  are  not  sufficient 
to  enable  the  corporation  to  pay  the  usual  dividend, 
the  dividend  equalization  reserve  may  be  drawn  upon. 
The  balance  is  available  for  dividends,  but  it  is  not 
usual  to  distribute  all  the  net  profits  of  any  one 
year.  The  dividends  distributed  are  deducted  from 
the  surplus  account  and  are  shown  as  surplus  adjust- 
ments. The  net  profits  of  sole  ownerships  and  part- 
nerships are  added  to  the  owners'  capital  accounts. 

19.  Deficits. — If  the  costs  and  expenses  of  a  year 
have  been  greater  than  the  total  income  received  from 
all  sources,  the  operations  for  that  period  have  re- 
sulted in  a  deficit.  If  a  corporation  has  a  surplus 
created  from  prior  periods,  the  deficit  from  opera- 
tions in  the  current  period  will,  of  course,  be  charged 
against  it.  If  the  surplus  is  still  sufficient  to  allow 
the  payment  of  the  usual  dividends,  the  board  of  di- 
rectors will,  in  all  probability,  make  the  usual  dis- 
tribution. If  no  such  surplus  exists,  however,  the 
capital  is  said  to  be  impaired.  In  other  words,  a  loss 
has  resulted  in  the  net  worth  or  in  the  proprietorship. 


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82    FINANCIAL  AND  BUSINESS  STATEMENTS 

converted  into  a  surplus,  the  inference  might  fairly  be 
made  that  an  inflation  of  the  inventory  was  responsi- 
ble for  the  conversion  of  the  deficit  into  the  surplus. 
Comparisons  with  preceding  periods  will  usually  re- 
veal practices  of  this  sort.  An  examination  of  a 
single  balance  sheet  or  of  a  single  income  account  is 
therefore  of  little  use.  The  financial  condition  and 
the  results  of  operation  should  always  be  studied  in 
comparative  form. 

REVIEW 

Enumerate  the  various  items  which  may  enter  into  selling  ex- 
penses.    How  is  their  exact  amount  determined? 

Distinguish  between  administrative  and  selling  costs,  and  ex- 
plain how  they  are  treated  in  the  accounts. 

Upon  what  does  net  profit  from  operation  depend,  and  what 
general  influences  determine  its  fluctuation? 

What  are  some  of  the  more  usual  charges  against  income  from 
operation  before  net  income  can  be  ascertained? 

Describe  methods  by  which  deficits  in  the  operations  of 
corporations  are  covered  up  in  the  books. 


CHAPTER  VI 

CONSOLIDATED  INCOME  STATEMENTS 

1.  Introduction, — Modern  developments  have 
brought  forth  new  forms  of  business  organizations, 
each  of  which  has  features  peculiar  to  itself.  The 
accounting  system  and  the  form  of  financial  state- 
ments adopted  by  the  various  types  of  business  organi- 
zations should  provide  a  clear  record  undisturbed  by 
any  unusual  features  of  organization.  As  in  any 
science,  the  general  principles  of  accounting  practice 
are  fixed  and  remain  constant  under  all  conditions. 
The  proper  method  of  applying  these  principles, 
however,  will  vary  with  the  individual  conditions  of 
each  undertaking  and  the  type  of  development  which 
it  portrays.  Therefore,  a  discussion  of  consolidated 
statements  must  be  prefaced  with  a  clear  understand- 
ing of  the  nature  of  these  new  forms  of  organization, 
the  results  of  whose  operations  can  best  be  disclosed 
thru  the  use  of  consolidated  statements. 

2.  Distinction  between  parent  and  holding  com- 
panies.— There  is  a  financial,  tho  not  a  legal  dis- 
tinction between  a  parent  and  a  holding  company  that 
is  not  always  understood.  A  parent  company  is  an 
operating  company  doing  business  under  its  own 
name    and    controlling,    thru    a   majority    of    stock 

83 


84     FINANCIAL  AND  BUSINESS  STATEMENTS 

ownership,  one  or  more  corporations  doing  business 
in  lines  allied  to  its  own.  The  subsidiary  companies 
are  new  corporations,  organized  by  the  parent  com- 
pany, which  retains  stock  control  for  itself  and  sells 
the  balance  of  the  stock,  if  need  be,  to  secure  either 
working  capital  or  local  stockholders. 

A  corporation  holding  a  valuable  patent  may  or- 
ganize subsidiary  corporations  which  are  practically 
selling  or  manufacturing  agencies.  The  parent  com- 
pany will  lease  the  patent  rights  to  the  subsidiaries 
for  use  in  certain  territories.  The  parent  company 
will  retain  at  least  the  majority  stock  ownership  in 
each  subsidiary  in  exchange  for  the  territorial  rights 
in  it.  At  the  same  time,  the  parent  company  may  be 
engaged  in  business  in  all  territories  not  leased. 
When  all  territories  are  leased,  the  parent  company 
will  cease  to  be  an  operating  company  and  will  then 
become  a  holding  company  of  the  pure  type. 

The  holding  company  is  not,  as  a  rule,  an  operating 
company,  altho  in  some  cases  it  may  be.  Its  princi- 
pal assets  are  the  stocks  and  bonds  of  corporations 
which  it  controls  thru  a  majority  ownership  of  the 
stocks  of  the  underlying  companies.  Frequently  it 
may  not  even  possess  office  equipment  as  its  principal 
office  may  be  that  of  one  of  its  subsidiaries. 

The  central  distinction  between  the  two  types  of 
companies  is  that  a  parent  company  organizes  and 
establishes  its  own  subsidiaries.  The  holding  com- 
pany acquires  the  ownership  thru  stock  control  of 
corporations  already  in  existence,  and  is  organized 


CONSOLIDATED  INCOME  STATEMENTS       85 

primarily  for  the  purpose  of  acquiring  such  stocks 
and  thereby  establishing  a  community  of  interest. 

In  the  discussion  which  follows,  the  term  "holding 
company"  will  be  used  in  a  general  sense  to  include 
any  type  of  combination  involving  stock  control  which 
one  corporation  exercises  over  other  corporations. 
The  principles  of  accounting  involved  remain  the 
same  whether  the  group  is  of  the  holding  or  parent 
company  type. 

3.  Ownership  of  the  stock  of  a  company  does  not 
mean  ownership  of  its  assets. — Let  us  consider  the 
legal  phases  involved  in  this  type  of  financial  organiza- 
tion. The  first  point  to  be  noted  is  that  under  the 
law,  ownership  of  stock  does  not  mean  ownership  of 
assets.  Thus,  if  corporation  "A"  owned  all  the 
stock  of  corporations  "B"  it  would  not  be  the  legal 
owner  of  corporation  "B's"  physical  property.  The 
title  to  corporation  "B's"  physical  property  rests  in 
the  artificial  person,  corporation  "B,"  and  it  can 
only  be  divested  of  that  property  by  due  process  of 
law. 

Corporation  "A,"  therefore,  is  in  the  same  posi- 
tion as  any  other  stockholder  of  the  corporation.  The 
right  of  a  stockholder  in  the  assets  of  a  corporation  is 
only  equitable.  The  ordinary  form  of  common  cap- 
ital stock  is  not  redeemable  and  the  stockholders, 
while  having  the  right  to  transfer  their  holdings,  can- 
not re-exchange  their  stock  for  the  assets  which  they 
surrendered  to  the  company  in  the  original  exchange 
for  the  stock. 


86    FINANCIAL  AND  BUSINESS  STATEMENTS 

Moreover,  it  has  often  been  decided  in  the  courts, 
that  the  income  or  profits  of  a  corporation  cannot  be 
secured  by  a  stockholder  unless  thru  a  formal  action 
of  the  Board  of  Directors  distributing  them  in  the 
form  of  dividends.  Therefore,  we  see  that  while  a 
stockholder  has  an  equitable  right  to  the  surplus  as- 
sets of  the  corporation  whose  stock  he  holds,  he  has 
not  an  enforceable  legal  right  to  secure  any  portion 
of  them  until  either  the  Board  of  Directors  has 
formally  voted  a  distribution  of  them,  or  until  the 
corporation  has  taken  the  necessary  legal  steps  to 
dissolve  its  existence. 

4.  Increase  in  value  due  to  economic  conditions  not 
to  be  recognized. — From  the  technical  accounting 
standpoint,  it  is  considered  improper  to  give  effect  in 
the  balance  sheet  to  the  increase  in  value  of  any  fixed 
asset  due  to  economic  conditions.  This  is  especially 
true  if  such  increase  is  to  be  credited  to  surplus  and 
made  available  for  dividends. 

Thus,  we  say  that  a  corporation  should  not  in- 
crease the  value  of  its  plant  land  on  its  books,  even 
tho  it  is  reasonably  sure  that  the  land  is  worth  more 
than  when  originally  purchased.  There  is  no  inten- 
tion of  making  a  sale  and  therefore  the  profit  cannot 
be  realized  and  the  increase  in  value  should  not  be 
credited  to  the  profit  and  loss  or  to  the  surplus  ac- 
count. Hence  it  would  follow  that,  according  to  our 
conception  of  income,  profits  actually  distributed,  or 
dividends  actually  received  by  a  stockholder,  consti- 
tute his  sole  source  of  income.     Earnings  not  yet  paid 


CONSOLIDATED  INCOME  STATEMENTS       87 

out  in  dividends  have  no  legal  existence  as  income  of 
the  stockholder. 

The  law  does  not  prohibit  a  stockholder  from 
carrying,  as  income,  dividends  which  his  company  has 
declared  out  of  capital.  True,  he  may  be  called  upon 
to  return  them  if  such  dividends  result  in  the  defraud- 
ing of  creditors,  but  if  they  merely  involve  impair- 
ment of  capital,  dividends  can  apparently  be  treated 
as  income  by  the  stockholder.  In  this  connection,  it 
should  be  noted  that  it  makes  no  difference  whether 
the  stockholder  owns  one  share  or  ninety-seven  per 
cent  of  the  stock  of  a  company. 

5.  A  balance  sheet  should  disclose  financial  condi- 
tion.— From  a  technical  accounting  standpoint,  the 
balance  sheet  of  a  business  purports  to  show  the  assets 
and  liabilities  which  it  owns.  Thus,  in  the  case  of  a 
holding  company,  its  principal  assets  would  be  the 
stocks  and  bonds  of  its  sub-companies;  its  lia- 
bilities would  probably  consist  of  notes  payable  and 
collateral  trust  bonds  or  notes  which  have  as  security, 
a  pledge  of  the  stocks  and  bonds  of  its  subsidiaries. 
Happily,  the  science  of  accounting  is  not  hedged  in 
by  narrow  bounds.  It  is  ready  to  forsake  the  old  for 
the  new  when  anything  is  to  be  gained  in  clearness, 
economy,  or  convenience  by  so  doing. 

6.  The  accountant  and  the  law. — Frequently,  an  ac- 
countant is  compelled  by  law  to  do  things  which  he 
knows  are  wrong.  In  common  with  his  fellow  men, 
however,  he  submits  to  the  law.  On  the  other  hand, 
where  he  is  not  absolutely  limited  by  the  law,  he 


88     FINANCIAL  AND  BUSINESS  STATEMENTS 

adopts  those  methods  which  he  knows  are  correct  ac- 
cording to  the  principles  of  his  science. 

The  law,  after  all,  is  nothing  more  than  the  crystal- 
lization of  human  experience  in  the  form  of  written 
enactment.  When  a  custom  or  a  practice  becomes 
sufficiently  well  established  among  men,  it  is  recog- 
nized and  sanctioned  by  an  enactment. 

7.  Accounting  practice  and  the  law  at  variance. — 
The  accountant  has  always  recognized  the  distinc- 
tion between  revenue  and  cash,  between  expense  and 
disbursements.  The  law,  even  to  this  day,  does  not 
always  recognize  that  distinction. 

The  accountant  has  recognized  the  necessity  of  pro- 
viding for  depreciation  before  determining  the  net 
profits  of  a  business  organization.  There  have  been 
numerous  court  decisions  in  which  a  provision  for  de- 
preciation before  the  ascertainment  of  net  profits  was 
disallowed. 

The  process  of  educating  legislators,  courts,  and  a 
large  number  of  business  men  in  accounting  methods 
has  been  a  slow  and  laborious  one  for  the  accountant, 
but  happily,  the  results  of  his  labors  are  already  be- 
ginning to  bear  fruit.  Many  of  the  principles  which 
have  been  rejected  heretofore  by  legislators  and  by 
judges  have  been  embodied  in  the  law  thru  the  rul- 
ings of  public  service  commissions.  If,  therefore,  the 
accountant  proceeds  along  the  lines  of  correct  prin- 
ciples, and  uses  scientific  methods  in  the  attainment 
of  his  desired  ends,  the  fact  that  current  legal  doctrine 
or  opinion  does  not  support  him,  is  of  small  impor- 


CONSOLIDATED  INCOME  STATEMENTS       89 

tance.  He  therefore  justifies  himself  in  preparing 
financial  statements  for  organizations  of  the  holding 
company  type  which  have  no  basis  or  standing  under 
our  present  legal  doctrine. 

8.  Pertinent  facts  which  should  be  shown  in  finan- 
cial statements. — The  accountant  clearly  recognizes 
that  in  preparing  financial  statements  for  any  organ- 
ization he  should  present  all  the  pertinent  facts  about 
the  financial  status  and  the  result  of  operation  of  the 
organization.  If  he  finds  that  the  presentation  of  a 
statement  of  assets  and  liabilities  of  a  holding  com- 
pany as  shown  by  its  books,  or  the  income  account 
of  a  holding  company  as  shown  by  its  ledger,  does  not 
truly  state  the  facts,  which  are  of  interest  and  im- 
portance to  the  stockholders,  he  must  present  the  in- 
formation in  such  form  as  will  properly  disclose  the 
facts.  The  accountant  clearly  recognizes  that  from 
the  point  of  view  of  the  stockholders  of  the  holding 
company,  the  legal  network  of  subsidiary  organiza- 
tions is  pure  fiction.  The  stockholders  of  the  hold- 
ing company  are  not  affected  at  all  by  the  relation 
existing  between  the  holding  company  and  its  sub- 
sidiaries, or  between  the  subsidiaries  themselves.  The 
relation  which  the  entire  group  has  to  outsiders,  credi- 
tors and  bondholders,  alone  are  matters  of  vital  im- 
portance. 

9.  Statements  in  form  of  balance  sheets  and  income 
accounts. — Realizing  that  the  balance  sheet  and  in- 
come account  of  a  holding  company  does  not  suffi- 
ciently show  the  relation  of  the  group  of  companies 


90     FINANCIAL  AND  BUSINESS  STATEMENTS 

to  outsiders,  the  accountant  prepares  a  statement  to 
convey  this  information.  These  statements  take  the 
form  of  combined  balance  sheets  and  income  accounts ; 
the  former  set  forth  the  combined  assets  and  liabili- 
ties, eliminating  inter-company  transactions,  and 
showing  only  the  liabilities  and  capital  stock  out- 
standing, due  to  or  held  by,  the  public.  Inter-com- 
pany sales  and  purchases  are  eliminated,  and  only 
those  purchases  and  sales  made  by  the  group  of  com- 
panies from  or  to  outsiders  are  included.  Many  dif- 
ficulties are  encountered  in  the  preparation  of  such 
statements,  and  some  of  these  will  be  considered  in 
the  present  chapter  and  in  a  later  chapter  dealing  with 
a  consolidated  balance  sheet. 

10.  Financial  results  stated  by  means  of  consoli- 
dated statements. — We  therefore  see  that  while  no 
existing  law  would  compel  a  holding  company  to  have 
its  financial  statements  made  up  in  the  manner  uni- 
versally agreed  upon  by  accountants,  and  while  we 
see  also  that  there  is  no  justification  in  law  for  the 
preparation  of  such  statements,  yet  a  logical  applica- 
tion of  the  fundamental  principles  of  the  science  of 
accounting  requires  that  the  financial  results  be  stated 
thru  the  means  of  consolidated  statements.  These  re- 
sults should  be  stated  in  such  a  manner  as  to  show 
the  income  of  the  aggregation,  eliminating  inter-com- 
pany transactions,  and  to  show  also  the  financial  posi- 
tion of  the  aggregation  in  so  far  as  it  is  affected  by 
the  rights  of  bondholders,  trade  creditors  and  minority 
stockholders. 


CONSOLIDATED  INCOME  STATEMENTS       91 

11.  Consolidation  of  statements. — In  passing,  it 
might  not  be  amiss  to  point  out,  that  consolidation  of 
statements  and  consolidated  statements  are  entirely 
dissimilar.  A  consolidation  of  statements  results 
when  a  combination  of  several  existing  companies  is 
contemplated.  The  promoter  of  this  combination 
wishes  to  know  how  the  consolidation  will  work  out 
and  what  will  be  the  probable  condition  of  the  new 
combination.  A  consolidation  of  statements  is  sim- 
ply the  totaling  of  all  items  on  each  individual  bal- 
ance sheet  into  one  combined  statement,  showing  the 
condition  of  the  companies  if  they  were  to  be  con- 
solidated. In  short  it  is  a  mere  mathematical  opera- 
tion. 

Consolidated  statements,  on  the  other  hand,  are 
prepared  periodically  after  the  combination  has  been 
formed,  to  show  the  progress  that  has  been  made  by 
the  group  as  a  whole.  Their  preparation  brings  up 
many  new  and  interesting  questions.  Some  of  the 
problems  involved  are  similar  to  those  discussed  in 
the  chapter  on  branch  accounts  in  the  Text  on  "Ac- 
counting Practice." 

It  will  be  evident,  then,  upon  reflection,  that  the 
balance  sheet  or  income  statement  of  a  holding  com- 
pany alone  would  simply  show  its  own  activities,  to- 
gether with  such  earnings  as  are  received  from  the 
dividends  distributed  by  subsidiaries,  and  the  interest 
earned  on  the  bonds  of  subsidiaries.  This  is  not  suffi- 
cient information  for  those  interested  in  the  holding 
company.     Many  changes — good  or  bad — may  have 

XXII— 8 


92     FINANCIAL  AND  BUSINESS  STATEMENTS 

taken  place  in  the  group  which  would  not  be  reflected 
in  the  holding  company's  statement. 

12.  Factors  not  disclosed  except  thru  the  medium 
of  consolidated  statements. — There  are  many  possible 
factors  which  might  be  entirely  overlooked  in  exam- 
ining the  financial  statements  of  holding  companies 
prepared  in  this  manner.  A  brief  consideration  of 
some  of  these  will  give  evidence  of  the  futility  of  such 
a  course.  In  this  connection,  it  may  also  be  men- 
tioned that  there  will  be  much  data  regarding  the  con- 
dition of  the  subsidiary  corporations  themselves  which 
will  not  be  disclosed  by  their  own  individual  state- 
ments. Moreover,  certain  other  factors  will  not  be 
clearly  in  evidence  even  if  one  examines  all  of  the 
statements  at  one  time — that  is,  if  the  financial  state- 
ment of  the  holding  company  and  its  subsidiaries  are 
available  for  comparative  examination.  The  multi- 
plicity of  items  and  the  difficulty  of  following  inter- 
company transactions  thruout  their  course  renders 
such  a  practice  of  little  value. 

13.  Division  of  profitable  business. — Some  of  the 
possible  manipulations  which  might  be  practiced  by 
dishonest  management  may  now  be  mentioned.  The 
executives  of  the  holding  company  may  turn  over  all 
the  renumerative  business  to  one  subsidiary,  and  all 
the  non-paying  business  to  another.  In  this  way, 
especially  if  there  was  a  large  minority  in  the  com- 
pany to  which  the  non-paying  business  was  turned 
over,  it  might  be  possible  to  wreck  the  second  com- 
pany.    Or  the  holding  company  might  be  loaded  with 


CONSOLIDATED  INCOME  STATEMENTS       93 

the  non-paying  business  only.  If  the  directors  owned 
considerable  stock  in  subsidiary  corporations  and  had 
but  a  small  interest  in  the  holding  company,  they 
would  draw  large  dividends  from  the  subsidiary  com- 
pany and  stand  but  a  small  part  of  the  loss  of  the 
holding  company.  Again,  as  more  frequently  hap- 
pens, the  management  might  turn  over  all  the  un- 
profitable business  to  a  subsidiary  which  would  show 
a  loss  in  operation,  while  the  holding  company  han- 
dling all  the  paying  business  would  be  able  to  show 
large  profits.  This  would  result  in  another  sort  of 
misstatement.  The  holding  company's  account 
would  indicate  that  a  profitable  business  was  being 
done,  and  the  investors  would  not  know  of  the  bad 
conditions  of  the  subsidiary  company. 

14.  Dividends  out  of  capital  may  remain  undis- 
closed.— Dividends  might  be  received  from  a  sub- 
sidiary company  which  would  be  carried  as  income  on 
the  books  of  the  holding  company.  It  might  happen 
also  that  such  dividends  were  declared  out  of  capital. 
The  accounts  of  the  holding  company  might  give  no 
evidence  of  this  fact  which  it  would  be  difficult  to  dis- 
cover from  the  separately  stated  accounts  of  the  sub- 
sidiary company.  On  the  other  hand,  dividends 
might  be  withheld  from  the  stockholders  of  the  sub- 
sidiary companies  thru  the  majority  control  by  the 
holding  company,  even  tho  the  subsidiary  could  well 
afford  to  pay  them.  This  would  result  in  depressing 
the  price  of  the  holding  company's  stock  thru  reduced 
earnings,  and  would  enable  the  directors  or  stockhold- 


94     FINANCIAL  AND  BUSINESS  STATEMENTS 

ers  who  were  aware  of  the  facts,  to  acquire  the  holding 
company's  stock  at  low  prices. 

15.  Advances  to  subsidiaries. — Advances  are  often 
made  by  the  holding  company  to  a  subsidiary  and  the 
subsidiary  may  in  turn  control  other  organizations  to 
which  it  advances  money.  These  advances  may  be 
carried  upon  the  books  of  the  lender  as  accounts  re- 
ceivable, current  advances,  or  notes  receivable,  if 
the  advances  are  represented  by  notes.  The  debtor 
corporation  may  have  invested  the  funds  in  fixed 
assets,  or  it  may  be  the  intention  of  the  debtor  to 
liquidate  the  advance  thru  an  additional  issue  of  its 
capital  stock  or  bonded  debt. 

It  is  evident  that  such  advances  are,  in  no  sense, 
current  assets.  Or,  what  may  be  even  still  more  un- 
favorable, the  advance  may  have  been  made  to  the 
debtor  corporation  for  the  purpose  of  making  good 
the  operating  losses.  To  any  one  examining  the  bal- 
ance sheet  of  the  creditor  company,  it  would  appear 
that  the  creditor  company  had  a  much  larger  fund  of 
current  receivables  than  was  actually  the  case. 

16.  Failure  to  provide  for  operating  losses  of  sub- 
sidiaries not  apparent. — Still  another  form  of  mis- 
statement that  might  be  indulged  in  would  consist  of 
having  the  holding  company  receive  as  dividends,  or 
even  largely  over-state,  the  profits  of  the  whole  group 
by  declaring  dividends  from  those  sub-companies 
which  had  made  profits,  while  failing  to  charge  the  in- 
come account  with  the  proper  provision  for  losses 


CONSOLIDATED  INCOME  STATEMENTS       95 

which  may  have  been  sustained  by  other  companies  of 
the  group.  All  of  these  factors  contribute  chiefly  to 
changes  in  the  market  prices  of  the  capital  stock  of 
the  holding  company.  By  presenting  information 
which  is  not  in  accordance  with  accounting  principles 
the  management  would  be  enabled  to  mislead  the  pub- 
lic, bringing  about  fluctuations  in  the  price  of  the 
holding  company's  stock  tho  not  actually  violating  the 
law. 

17.  Balance  sheets  should  be  consolidated. — The 
failure  to  consolidate  the  income  accounts  of  the  sub- 
sidiaries probably  does  not  result  in  as  great  disad- 
vantage as  would  the  failure  to  consolidate  the  bal- 
ance sheets.  The  failure  to  eliminate  inter-company 
sales  and  inter-company  purchases  would  of  course 
result  in  an  overstatement  of  purchases  as  well  as 
sales.  The  failure  to  eliminate  the  inter-company 
profits  represented  in  the  inventory  would  naturally 
result  in  an  overstatement  of  the  profits  for  the  pe- 
riod, because  it  will  be  realized  that  the  inventory 
is  an  essential  and  important  part  of  the  income  ac- 
count. 

Likewise  all  inter-company  construction  work  per- 
formed by  an  affiliated  company,  and  prepaid  ex- 
penses of  inter-company  origin,  should  be  carried  in 
the  consolidated  statements  only  at  cost,  net  of  any 
inter-company  profit.  The  expenses  of  one  company 
are  set  against  the  earnings  of  another  and  both 
are  eliminated  from  the  consolidated  statement.     The 


96     FINANCIAL  AND  BUSINESS  STATEMENTS 

working  papers  required  to  prepare  consolidated  in- 
come accounts  are  made  up  practically  on  the  same 
basis  as  those  covering  the  consolidated  balance  sheet 
illustrated  on  pages  247,  248. 

18.  Inter-company  transactions. — To  illustrate  how 
these  inter-company  transactions  are  eliminated  from 
the  inventories,  construction  accounts,  etc.,  in  the  con- 
solidated income  account,  we  will  suppose  that  a  hold- 
ing company  controls,  among  other  concerns:  a  min- 
ing company  "A";  a  steamship  line,  "B";  a  steel  com- 
pany, "C";  a  railroad,  "D";  and  a  rolling  mill  "E." 
The  mine  produces  ore,  and  sells  for  $100,000  at  a 
profit  of  $17,000  to  the  steel  company  (C).  It  is 
shipped  via  the  steamship  line  (B)  at  a  freight  cost  of 
$3,000  (profit  $900).  The  steel  company  expends 
$37,000  in  manufacturing  this  ore  into  steel  valued  at 
$150,000.  It  sells  $50,000  worth  to  outsiders  and 
$75,000  to  the  affiliated  company  "E  "  This  $75,000 
worth  of  steel  is  shipped  to  the  "E"  company  over  the 
railroad  "D"  at  a  freight  cost  of  $3,000  (profit  $600) . 
The  "E"  company  manufactures  this  steel  into  steel 
rails  at  a  manufacturing  cost  of  $12,000  and  derives 
a  profit  of  $10,000.  Of  this  $100,000  worth  of  steel 
rails,  they  sell  $25,000  to  outsiders  and  $50,000  to 
the  affiliated  railroad  companies.  The  railroad  has 
consumed  one-half  of  these  steel  rails  by  the  time  the 
consolidated  statement  is  to  be  prepared.  We  would 
set  up  our  schedule  of  these  transactions  somewhat  as 
follows : 


CONSOLIDATED  INCOME  STATEMENTS       97 

„ri»  nnMPANV  Gross  Cash  Inter-Co.  Profit 

Purchases $100,000               $17,000 

freight 3,000                       900 

Manufacturing  Cost   37,000 

Manufacturing  Profit 10,000                  10,000 

Total   $150,000  $27,900 

Sold  to  Outsiders $  50,000  $  9,300 

Sold  to  Affiliated  Companies 75,000  13,950 

Total    $125,000  $23,250 

Inventory  at  Selling  Price $25,000  $  4,650 

"E"  COMPANY 

Purchases     $  75,000                $13,950 

Freight    3,000                       600 

Manufacturing  Cost   12,000                  10,000 

Manufacturing  Profit 10,000 

Total   $100,000  $24,550 

Sold  to  Outsiders   $  25,000  $  6,137.50 

Sold  to  Affiliated  Companies 50,000  12,275. 

Total    $  75,000  $18,412.50 

Inventory  at  Selling  Price $  25,000  $  6,137.50 

"D"  COMPANY 

Purchases     $  50,000  $12,275. 

Consumed     25,000  6,137.50 

Inventory  at  Cost  Price $  25,000  $  6,137.50 

The  consolidated  statement  would  pick  up  the 
$75,000,  inventories  (the  total  of  three  inter-com- 
panies' inventory  profits),  less  $16,925  of  inter-com- 
pany profit.  The  amount  of  inter-company  profits 
going  with  any  sale,  either  to  outsiders  or  to  affiliated 
companies,  depends  upon  the  ratio  of  the  amount  of 
that  sale  to  the  total  sale. 

It  will  be  noticed  that  the  inventories  which  we  have 


98     FINANCIAL  AND  BUSINESS  STATEMENTS 

left  for  each  company  are  figured  at  the  cost  to  each 
company,  plus  their  own  percentage  of  profit.  This 
was  done  simply  for  the  sake  of  clearness  in  the  illus- 
tration. Of  course,  these  inventories  would  not  be 
carried  in  their  own  balance  sheets  at  a  figure  which 
included  their  own  profit.  For  the  purposes  of  the 
consolidated  statement,  however,  the  reader  will  see 
that  the  profit  is  entirely  eliminated. 

It  is  more  frequently  the  custom  to  record  the  in- 
ter-company profits  on  the  stock  records  at  the  time 
of  purchase.  The  inventory  will  then  show  the  in- 
ter-company profits  without  the  need  of  such  an 
elaborate  schedule  as  given  above. 

19.  Inter-company  profits  on  construction. — A 
slightly  different  situation  results  in  connection  with 
profits  on  inter-company  construction.  They  must 
be  charged  back  thru  the  books  of  the  holding  com- 
pany when  they  are  paid  out  by  the  profiting  cor- 
poration as  dividends.  If  the  construction  was  done 
for  the  holding  company,  this  company  will  simply 
credit  the  dividends  to  the  construction  account.  If, 
however,  the  construction  was  done  for  some  other 
affiliated  company,  the  transfer  must  be  made  thru 
the  books  of  the  holding  company.  The  holding  com- 
pany will  credit  the  inter-company  profits  received  as 
dividends,  to  the  company  for  which  the  construction 
was  done.  This  company  will,  in  turn,  credit  the 
same  amount  to  the  asset,  construction  account. 

The  advances  between  subsidiaries,  or  the  notes 
given  between  subsidiaries,  usually  bear  interest;  or 


CONSOLIDATED  INCOME  STATEMENTS       99 

the  note  of  a  subsidiary  may  be  discounted  by  the 
holding  company  resulting  in  the  creation  of  a  de- 
ferred asset,  "discount  paid  in  advance,"  on  the  books 
of  the  subsidiary  company.  It  is  evident,  of  course, 
that  interest  paid  or  earned  on  such  inter-company 
transactions  is  another  item  to  be  eliminated  from  the 
income  statement. 

REVIEW 

Distinguish  between  a  parent  company  and  a  holding  com- 
pany. Does  this  distinction  have  any  significance  for  accounting 
methods  ? 

If  company  A  owns  100  per  cent  of  the  stock  of  Company  B, 
does  it  own  the  assets  of  the  latter? 

Describe  the  usual  balance  sheet  of  a  holding  company  and 
compare  it  with  a  consolidated  balance  sheet. 

What  is  the  value  of  consolidated  balance  sheets  and  income 
statements?  Describe  some  of  the  irregularities  which  such  con- 
solidated statements  may  disclose. 


CHAPTER  VII 

VALUATION  AND  INTERPRETATION  OF  FIXED 

ASSETS     * 

1.  Fixed  or  capital  assets. — The  assets  designated 
as  fixed  or  capital  assets  are  those  of  a  permanent  na- 
ture which  a  business  organization  has  acquired,  and 
which  are  generally  financed  thru  the  issue  of  capital 
stock  or  bonds.  In  some  instances,  assets  of  this  char- 
acter are  financed  thru  surplus,  but  in  any  event  they 
represent  that  portion  of  the  capital  investment  which 
the  company  does  not  intend  to  dispose  of,  or  which 
could  not  be  disposed  of  without  seriously  crippling 
the  operation  of  the  business.  Assets,  the  utility  of 
which  lasts  less  than  one  year  from  the  date  when  they 
are  placed  in  service,  ordinarily  should  not  be  included 
under  this  group. 

2.  Real  estate,  or  real  property. — Published  bal- 
ance sheets  frequently  show  "real  estate,"  or  "real 
property,"  which  includes  land,  land  improvements, 
lease-holds  and  buildings.  Real  property  is  the  right 
to  use  and  enjoy  land.  Under  the  law  of  real  prop- 
erty, buildings  or  permanent  structures  erected  on  the 
land  become  a  part  of  it.  While  this  is  the  legal  view, 
from  the  accounting  viewpoint  a  sharp  distinction  is 

drawn  between  land  and  buildings.     The  reason  for 

100 


VALUATION  OF  FIXED  ASSETS  101 

this  is  that  the  accountant  is  forced  to  consider  the 
question  of  depreciation  in  connection  with  buildings, 
and  it  is  advisable  to  keep  separate  accounts  for  the 
component  parts  of  the  real  property  investment. 

3.  Plant  land  distinguished  from  land  held  as  an 
investment. — The  account  for  plant  land  should  be 
charged  with  the  value  of  the  land  acquired  strictly  for 
the  purpose  of  manufacturing  or  trading  operations. 
Business  firms  will  occasionally  make  investments  in 
land  for  other  purposes,  such  as  for  development  in 
connection  with  housing  schemes  for  employes,  and 
the  like.  Land  acquired  for  such  purposes  is  es- 
sentially an  investment  and  will  ordinarily  receive  dif- 
ferent treatment  in  the  accounts. 

4.  Valuation  of  plant  land. — The  account  with 
plant  land  should  be  charged  at  the  time  of  purchase 
with  the  actual  cost  of  the  land,  whether  it  is  paid  for 
in  cash  or  in  securities.  It  is  proper  to  include  in  the 
cost  all  the  necessary  and  incidental  expenses  in  con- 
nection with  the  acquisition  of  the  property,  such  as 
the  cost  of  title-searching  or  the  registration  of  title, 
broker's  commission  or  fee,  the  cost  of  recording  the 
deeds  and  conveyancing,  taxes  accrued  up  to  the  date 
of  the  transfer  of  title,  and  other  liens  or  assessments 
levied  against  the  property  at  the  date  of  its  acquisi- 
tion. 

5.  Land  improvements. — While  the  cost  of  improv- 
ing land  or  rendering  it  suitable  for  the  purposes  for 
which  it  is  intended  to  be  used,  is  frequently  merged  in 
the  land  account,  it  is  generally  advisable  to  keep  a 


102     FINANCIAL  AND  BUSINESS  STATEMENTS 

separate  account  for  the  cost  of  these  improvements. 
It  may  be  necessary  to  drain  the  land  and  to  fill  in 
swamps;  it  may  be  necessary  to  cut  down  embank- 
ments. In  fact,  any  improvements  of  a  permanent 
nature  which  add  to  the  value  of  the  land,  and  render 
it  suitable  for  the  purposes  for  which  it  is  to  be  em- 
ployed are  properly  chargeable  to  this  account. 

6.  Land  investment.— The  general  principles  out- 
lined in  the  preceding  paragraph  apply  to  land  pur- 
chased primarily  for  investment.  The  cost  of  any 
improvements  made  to  land  investments  should  also 
be  carried  in  a  separate  account.  It  must  be  remem- 
bered, however,  that  land  of  this  character  will  not 
produce  any  revenue  under  ordinary  conditions. 
There  will  be  annual  carrying  charges  for  taxes  and 
for  interest  on  borrowed  money,  and  for  statistical 
purposes  it  is  probably  desirable  to  add  expenditures 
of  this  kind  to  the  value  of  the  land.  Accordingly, 
the  problem  is  to  measure  the  cost  of  this  unproduc- 
tive investment.  However,  where  the  method  of  cap- 
italizing the  ordinary  maintenance  expenses  is  fol- 
lowed, a  reserve  equivalent  to  the  amount  of  the  an- 
nual capitalized  charges  should  be  set  aside  out  of 
profits.  The  reason  for  this  is  that  if  the  land  is  ul- 
timately disposed  of,  such  capitalized  charges  may  not 
be  recovered.  Accordingly  the  failure  to  provide  for 
a  reserve  would  inflate  the  surplus  and,  in  the  case  of 
a  corporation,  these  capitalized  expenditures  would 
be  made  available  for  dividends. 

7.  The  treatment  of  land  as  stock  in  trade. — The 


VALUATION  OF  FIXED  ASSETS  103 

treatment  of  land  purchased  by  a  real  estate  concern 
for  development  and  subsequent  sale  will  be  different 
from  that  outlined  above.  No  difficulty  will  be  en- 
countered in  transactions  of  this  kind  if  we  realize 
the  fact  that  the  land  is  similar  to  raw  material  pur- 
chased by  a  manufacturing  concern  for  the  manufac- 
ture of  finished  products.  The  cost  of  grading,  street- 
openings,  sidewalks,  and  sewer  and  water  connections, 
all  enhance  the  value  of  the  property  and  should 
be  capitalized.  Taxes,  interest  on  purchase-money 
mortgages,  and  all  carrying  charges  during  the  pe- 
riod of  development  may  also  be  capitalized. 

It  is  customary  in  real  estate  developments  to  keep 
costs  by  plots.  Each  plot  is  then  cut  up  into  a  cer- 
tain number  of  lots,  and  the  total  expense  of  the  de- 
velopment divided  by  the  number  of  lots  will  be  the 
cost  per  lot.  When  a  sale  is  made,  the  proceeds  of 
the  sale  are  in  part  a  realization  of  the  capital  in- 
vestment and  in  part  a  realization  of  profit.  In  or- 
der to  determine  that  portion  which  represents  a  re- 
turn of  capital  and  that  portion  which  may  properly 
be  taken  to  the  credit  of  the  profit  and  loss  account,  it 
is  necessary  to  keep  accurate  costs  by  plots  or  lots. 

While  capital  charges  ordinarily  cease  after  the 
property  is  fully  developed,  in  order  to  determine  the 
real  profitableness  of  the  undertaking  it  is  customary 
to  capitalize  interest  charges,  running  expenses  and 
taxes  even  after  the  development  has  been  completed. 
This  is  for  the  purpose  of  estimating  not  only  the  total 
cost  to  develop,  but  also  the  cost  of  carrying  each  in- 


104     FINANCIAL  AND  BUSINESS  STATEMENTS 

dividual  lot.  However,  if  this  method  is  followed, 
carrying  charges  capitalized  after  operations  have  be- 
gun should  be  offset  by  the  creation  of  a  suitable  re- 
serve against  the  possibility  of  the  failure  to  realize 
such  carrying  charges  when  the  lots  are  ultimately 
sold.  Upon  the  subsequent  sale  of  lots,  the  reserve 
created  with  respect  to  this  particular  lot,  or  the  por- 
tion of  the  general  reserve  created  with  respect  to  this 
particular  lot,  will  be  adjusted,  and  such  portion  of  it 
as  has  been  realized  in  the  sales  price  of  the  lot  will  be 
released  to  surplus. 

8.  The  valuation  of  leaseholds  and  leasehold  rights, 
— With  reference  to  leaseholds,  it  is  important  to  note 
the  length  of  the  life  of  the  lease.  The  benefit  of  all 
expenditures  made  either  for  land  improvements  or 
for  buildings  upon  leased  land,  will  pass  ordinarily  to 
the  landlord  at  the  expiration  of  the  lease.  Conse- 
quently any  value  paid  for  the  lease,  or  any  expendi- 
ture incurred  upon  leased  property,  must  be  written 
off  during  the  life  of  the  lease.  When  a  party  takes 
land  under  lease  and  makes  extraordinary  improve- 
ments, the  lease  frequently  is  drawn  with  a  provision 
in  which  the  landlord  agrees  to  pay  a  fixed  sum,  at  the 
expiration  of  the  term,  to  the  tenant  for  the  tenant's 
improvements.  This  factor  must  be  taken  into  con- 
sideration in  valuing  a  leasehold. 

In  other  cases,  a  firm  may  have  sublet  its  lease- 
hold rights,  and  the  question  of  the  valuation  of  the 
leasehold  may  arise.  Ordinarily  such  contracts  are 
not  capitalized,  and  the  question  of  their  value  would 


VALUATION  OF  FIXED  ASSETS  105 

probably  not  arise  except  in  the  case  of  a  partnership, 
when  it  might  be  necessary  to  determine  the  value  of 
a  deceased  partner's  interest.  The  annual  income  to 
be  enjoyed  from  the  lease,  less  all  carrying  charges, 
may  be  considered  as  an  annuity  for  the  number  of 
years  that  the  lease  has  to  run,  and  from  the  compound 
interest  tables  the  present  worth  of  the  annuity  can 
be  worked  out.  Any  sum  recoverable  from  the  land- 
lord at  the  expiration  of  the  term  of  the  lease  may  be 
valued  by  finding  its  present  worth  from  the  com- 
pound interest  tables  at  an  assumed  rate  of  interest. 

9.  Mineral  land  and  timber  property. — The  prin- 
ciples of  valuation  are  difficult  to  apply  in  cases  of 
wasting  assets.  Every  dollar's  worth  of  ore  taken 
from  a  mine,  or  every  gallon  of  oil  from  an  oil  well, 
reduces  the  value  of  the  land  for  the  purposes  for 
which  it  was  acquired.  The  proceeds  of  sales  are 
represented  in  part  by  a  return  of  the  capital  invest- 
ment and  in  part  by  a  realized  profit.  Because  of 
the  difficulty  of  arriving  at  these  amounts,  mining 
companies,  as  a  rule,  do  not  make  any  provision  for 
the  conservation  of  the  capital  investment,  but  they 
customarily  pay  out  all  the  net  proceeds  of  current 
operation  as  dividends. 

Where  the  purchase  of  land,  containing  mineral 
wealth  has  been  financed  thru  an  issue  of  bonds,  there 
will  usually  be  a  provision  in  the  indenture  creating  a 
sinking  fund  for  the  ultimate  redemption  of  the  debt. 

It  is  not  generally  considered  desirable  in  mining 
companies  to  provide  a  reserve  for  exhaustion,  for  the 


106     FINANCIAL  AND  BUSINESS  STATEMENTS 

reason  that  the  creation  of  the  reserve  results  in  with- 
holding large  sums  of  cash  in  the  company's  treasury. 
This  fund  may  not  be  safely  invested  in  additional 
mineral  wealth;  it  will  draw  a  small  rate  of  interest 
and  it  may  be  used  for  speculation  by  the  board  of 
directors  or  otherwise  mismanaged. 

Moreover,  the  approximate  recovery  from  a  gold  or 
copper  mine  is  a  difficult  thing  to  determine ;  in  fact, 
it  probably  cannot  ordinarily  be  determined  with  any 
reasonable  degree  of  accuracy.  On  the  other  hand,  a 
competent  geologist  may  be  able  to  determine  the 
approximate  recovery  of  a  coal  mine.  The  produc- 
tion life  of  an  oil  well  is  purely  speculative.  Stock- 
holders and  investors  in  enterprises  of  this  character 
must  realize  that  every  dollar's  worth  of  dividends  is 
in  part  a  return  of  capital  investment,  unless  the  or- 
ganization is  providing  a  reserve  for  exhaustion. 
Furthermore,  the  investment  of  a  reserve  for  exhaus- 
tion in  additional  land  may  not  be  desirable  for,  in 
many  instances,  the  carrying  cost  of  such  investments 
will  prove  excessive  and  the  investors  in  the  under- 
taking will  find  themselves  land-poor. 

The  valuation  of  timber  properties  is  also  a  very 
difficult  matter.  It  is  true,  that  expenditures  upon 
growing  timber  will  usually  be  recovered  and  reflected 
in  the  increased  size  and  value  of  the  timber.  How- 
ever, if  scientific  reforestation  is  not  employed,  the 
proceeds  of  sales  are  a  return,  in  part,  of  capital  in- 
vested and,  in  part,  of  net  profit. 

Assets  of  this  character  are  also  subject  to  fire 


VALUATION  OF  FIXED  ASSETS  107 

hazards,  in  the  case  of  timber  property,  and  floods  in 
the  case  of  mines.  These  agencies  may  destroy  a 
large  part  of  the  capital  invested  or  cause  great  loss 
to  stockholders.  If  contingencies  of  this  character 
have  not  been  provided  for  thru  the  medium  of  ade- 
quate reserves,  the  investor  or  stockholder  must 
take  this  into  consideration  in  the  valuation  of  his 
interests. 

10.  Depreciation  or  appreciation  of  land. — Fluc- 
tuations in  the  value  of  land,  due  to  economic  condi- 
tions, should  be  ignored.  This  has  already  been 
pointed  out  in  the  volume  on  "Accounting  Practice." 
Heretofore,  consideration  of  possible  depreciation  of 
plant  land  was  not  necessary.  The  shifting  of  in- 
dustry, however,  may  cause  it  to  be  an  important  fac- 
tor against  which  a  reserve  for  loss  in  the  value  of 
land  may  be  appropriate.  We  are  all  familiar  with 
loss  in  the  value  of  land  used  for  manufacturing  pur- 
poses, which  is  caused  by  a  relocation  or  shifting  of 
the  industry.  Along  the  line  of  almost  any  railroad 
one  may  see  large  factories  idle,  because  of  either 
labor  conditions  or  a  shifting  of  the  market  for  fin- 
ished material,  or  the  opening  up  of  new  sources  of 
raw  materials,  which  made  it  more  advantageous  for 
the  firm  to  abandon  its  present  quarters  and  locate 
elsewhere.  This  contingency  should  be  considered  in 
valuing  land  used  for  plant  purposes. 

11.  Important  points  in  the  valuation  of  buildings 
and  structures. — When  a  firm  acquires  buildings, 
which  have  already  been  erected,  their  valuation  will 

XXII— 9 


108     FINANCIAL  AND  BUSINESS  STATEMENTS 

be  fixed  by  the  board  of  directors  at  the  date  of  ac- 
quisition and  will  be  based  upon  the  amount  paid  for 
them.  When  a  corporation  erects  its  own  buildings, 
it  may  undertake  to  do  the  work  itself,  furnishing  the 
material,  labor  and  supervision,  or  it  may  award  the 
contract  to  a  construction  company.  In  the  latter  in- 
stance, the  contract  price  will  fix  the  value  of  the 
structure.  When  the  organization  undertakes  to  do 
its  own  construction,  the  cost  of  the  structures  will 
include  the  cost  of  all  materials  used,  the  cost  of  the 
labor  necessary  to  erect  the  structure,  and  the  cost  of 
foundations  and  sub-structures,  including  water  mains 
and  similar  items.  It  would  be  proper  also  to 
charge  to  cost  of  construction  fees  paid  for  the  draw- 
ing of  plans  and  specifications  or  supervision  fees 
paid  to  an  architect.  Any  proportion  of  the  time 
spent  by  the  administrative  staff  of  the  organization 
in  supervising  the  work  of  construction  may  also  be  so 
charged.  It  is  also  proper  to  capitalize  subsistence 
charges  and  transportation  expenses  of  laborers  or 
supervisors  who  may  be  employed.  In  fact,  all  the 
incidental  and  relevant  expenses  incurred  in  con- 
structing the  buildings  should  be  charged  in  this  way. 

Any  interest  paid  on  borrowed  money  used  in 
financing  the  construction  of  the  building,  may  be 
properly  charged  to  its  cost  until  the  building  is  com- 
plete and  ready  to  operate. 

It  should  be  noted  that  there  are  differences  of 
opinion  about  the  treatment  of  discounts  on  securities 
issued  or  debts  incurred  in  financing  construction. 


VALUATION  OF  FIXED  ASSETS  109 

The  best  American  practice,  at  present,  does  not  favor 
charging  this  item. 

On  the  other  hand,  in  England,  under  certain  con- 
ditions, a  corporation  that  issued  stock  to  finance  the 
construction  of  a  building  might  be  allowed  to  pay  a 
reasonable  dividend  on  the  capital  stock  during  the 
time  the  money  was  being  employed  in  constructing 
the  building  and  getting  it  ready  for  operation.  The 
amount  of  the  dividend  so  declared  would  be  charged 
to  construction  account. 

Some  authorities  hold  that  interest  on  borrowed 
money  used  in  construction  should  not  be  charged 
to  the  cost  of  structure.  The  reason  advanced  is  that 
the  method  of  financing  the  construction  of  a  build- 
ing has  nothing  to  do  with  its  cost.  However,  the 
weight  of  authority  at  the  present  time  seems  to  be  op- 
posed to  this  theory. 

Any  insurance,  either  fire,  employer's  liability  or 
general  liability,  paid  during  the  period  of  construc- 
tion is  a  proper  charge  to  the  construction  account. 

It  is  sometimes  necessary  to  demolish  a  structure 
for  the  purpose  of  erecting  a  new  one.  There  are  two 
theories  about  the  treatment  of  the  loss  occasioned  by 
the  demolition  of  the  existing  structure.  One  is  that 
the  loss  is  a  necessary  and  incidental  expense  in  the 
erection  of  the  new  structure,  and  therefore  should  be 
capitalized  in  the  cost  of  the  construction.  The  other 
theory  has  supporting  it  the  economic  doctrine  of  the 
place  value  of  land.  It  would,  of  course,  be  an  un- 
wise proceeding  for  a  concern  to  purchase  land  and 


110     FINANCIAL  AND  BUSINESS  STATEMENTS 

pay  for  an  existing  structure  only  to  demolish  it  to 
make  way  for  a  new  establishment.  In  fact,  a  busi- 
ness undertaking  would  not  be  likely  to  do  this  unless 
it  were  distinctly  profitable  for  it  to  have  its  plant  lo- 
cated, or  the  new  structure  erected,  upon  this  particu- 
lar parcel  of  land. 

12.  Repairs,  renewals,  additions,  betterments  and 
replacements. — Any  considerations  of  the  subject  of 
the  valuation  of  building  necessarily  must  deal  with 
these  items.  They  have  been  so  fully  discussed  in  the 
volume  on  "Accounting  Practice,"  however,  that  it  is 
necessary  here  only  to  call  attention  to  the  fact  that  the 
valuation  of  assets  in  the  balance  sheet  must  always 
be  considered  with  the  qualification  that  the  business 
has  made  the  proper  differentiation  between  capital 
and  revenue  expenditure. 

13.  Importance  of  segregating  the  investment  in 
equipment. — The  equipment  account  will  include  the 
expenditure  for  building  equipment  and  power-plant 
equipment,  such  as  boilers,  dynamos,  engines,  heat- 
ing plant,  ventilating  system,  and  water  connec- 
tion. 

It  is  not  our  purpose  here  to  discuss  at  length  an 
ideal  classification  of  equipment,  even  if  such  a  classi- 
fication could  be  prepared.  It  will  be  sufficient  to  ob- 
serve the  general  principles  upon  which  equipment 
may  be  classified.  One  of  these  is  according  to  the 
life  of  the  equipment,  that  is,  classifying  all  units  with 
the  same  relative  period  of  utility  in  special  accounts, 
so  as  to  enable  the  provision  for  depreciation  to  be  as- 


VALUATION  OF  FIXED  ASSETS  111 

certained  more  readily.  It  may  also  be  classified  ac- 
cording to  kind.  In  this  division  under  the  account, 
"boilers  and  accessories,"  would  be  included  all  of  the 
boilers  and  boiler  apparatus  and  accessories  that  were 
being  used  in  the  production  of  steam.  These  would 
include  the  valves,  main  steam  line,  grates  and  flues, 
smokestacks  and  chimneys,  and  foundations  and  set- 
tings, together  with  mechanical  stokers  and  ash  re- 
movers, etc.,  etc.  The  entire  investment  in  this  class 
of  equipment  might  appropriately  be  carried  in  one 
account.  Still  a  third  method  of  classifying  equip- 
ment might  be  according  to  the  manufacturing  units. 
All  property  investments  would  be  classified  in  the 
general  ledger  by  operating  units  or  plants,  and  a  sub- 
sidiary record  for  each  unit,  setting  forth  classes  or 
kinds  of  equipment,  would  be  provided.  Whichever 
method  is  used,  it  must  be  remembered  that  certain 
kinds  of  equipment  which  are  installed  in  leased  prop- 
erty may  become  part  of  the  realty  and  may  not  be  re- 
moved. Consideration  must  be  given  to  this  factor 
when  any  of  the  property  of  an  undertaking  is  occu- 
pied under  lease. 

14.  Machinery  and  fixed  tools. — Ordinarily  the 
general  ledger  would  show  a  machinery  and  fixed 
tools  account,  and  if  the  investment  is  at  all  large,  a 
subsidiary  record  should  be  provided  for  equipment  of 
this  class.  The  reader  will  recall  that  in  the  volume 
on  "Accounting  Practice"  certain  principles  concern- 
ing the  valuation  of  machinery  and  equipment  were 
discussed,   especially  the  treatment  to  be  given  to 


112     FINANCIAL  AND  BUSINESS  STATEMENTS 

equipment  manufactured  by  the  organization  itself. 
Tools  and  equipment  having  a  period  of  utility  of  less 
than  one  year,  should  not  be  charged  to  this  account. 
Because  of  the  necessity  of  replacing  them  immedi- 
ately, it  is  better  to  charge  such  tools  and  equipment 
direct  to  the  income  account.  If  this  practice  is  fol- 
lowed, the  original  outlay  for  short-life  equipment 
can  be  capitalized  and  it  would  then  represent  the 
total  sum  necessary  properly  to  equip  the  organiza- 
tion with  these  short-life  assets.  This  procedure 
would  avoid  the  unsatisfactory  and  time-consuming 
method  of  providing  annually  for  depreciation  on 
equipment  of  this  type. 

15.  The  valuation  of  furniture  and  fixtures. — This 
asset  may  be  subdivided  between  the  furniture  and 
fixtures  in  the  manufacturing  plant  and  that  in  the 
general  office  or  in  branch  offices.  It  consists  of  all 
furniture,  machines  and  devices  for  calculating  or  for 
clerical  use,  lighting  fixtures,  partitions,  and  the  like. 
In  dealing  with  this  asset,  it  is  not  uncommon  for  firms 
to  capitalize  the  expense  of  a  complete  and  adequate 
outfit,  and  charge  any  annual  expenditures  incurred 
subsequently  in  renewals  or  replacements,  direct  to 
the  expense  account.  Other  organizations  find  more 
satisfactory  the  method  of  capitalizing  all  new  pur- 
chases and  writing  off  depreciation  periodically. 
Most  conservative  organizations  follow  the  practice 
of  depreciating  these  assets  rapidly  because,  if  aban- 
doned, they  are  worth  very  little  for  scrap.  A  bank- 
ing organization  will  write  down  its  building  and  fix- 


VALUATION  OF  FIXED  ASSETS  IIS 

tures  much  more  rapidly  than  would  the  ordinary 
manufacturing  organization.  It  is  true,  this  creates 
a  secret  reserve,  but  it  is  considered  good  business 
policy  in  organizations  of  this  type. 

16.  The  principles  employed  in  the  valuation  of 
stable  and  garage  equipment, — Horses  and  mules  are 
ordinarily  revalued  from  year  to  year  by  appraisal. 
Automobile  trucks  are  usually  depreciated  at  the  rate 
of  from  20  to  33%  per  cent.  The  balance  of  the 
stable  equipment  will  ordinarily  be  depreciated  at 
rates  from  12%  to  20  per  cent. 

17.  Patterns,  drawings,  and  dies. — It  will  not  be 
necessary  here  to  amplify  the  discussion  dealing  with 
the  class  of  assets  represented  by  patterns,  drawings, 
dies  and  the  like,  which  the  reader  has  already  found 
in  the  volume  on  "Cost  Finding."  Care  and  discre- 
tion and  a  great  deal  of  common  sense  must  be  used 
in  the  valuation  of  these  assets.  The  failure  to  pro- 
vide adequately  for  depreciation  is  a  very  common 
occurrence,  and  if  an  asset  of  this  kind  appears  in  a 
published  balance  sheet  for  a  large  amount,  the  stock- 
holder or  investigator  is  justified  in  regarding  it  with 
considerable  suspicion. 

18.  The  general  problem  of  depreciation. — Atten- 
tion has  already  been  called,  in  the  Texts  on  "Ac- 
counting Principles"  and  on  "Accounting  Practice," 
as  well  as  in  that  on  "Cost  Finding,"  to  the  general 
subject  of  depreciation,  its  importance,  the  methods  of 
providing  for  it,  and  the  necessity  of  giving  it  due 
recognition  in  the  accounts.     Our  interest  at  present 


114*    FINANCIAL  AND  BUSINESS  STATEMENTS 

lies  in  the  general  subject  from  the  point  of  view  of 
the  interpretation  of  a  balance  sheet. 

If  depreciation  reserves  appear  on  a  balance  sheet 
merged  with  other  reserves  or  with  surplus,  as  is  very 
often  the  case,  a  just  suspicion  may  arise  that  this 
method  of  combining  the  reserves  and  the  surplus  has 
been  adopted  because  of  the  fact  that  the  depreciation 
provisions  are  not  adequate.  If  the  reader  of  a  pub- 
lished balance  sheet  has  the  current  income  account  at 
hand,  perhaps  he  may  satisfy  himself  as  to  the  ade- 
quacy of  the  depreciation  provision  for  the  current 
period.  But  this  will  not  be  an  indication  which  may 
always  be  relied  upon.  Some  firms  often  follow  the 
practice  of  providing  heavily  for  depreciation  in  pros- 
perous years  and  ignoring  the  provision  during  lean 
years. 

19.  Special  factors  to  be  considered  in  interpreting 
a  balance  sheet. — The  assets  which  we  have  described 
above  comprise  the  tangible  fixed  capital  of  ordinary 
undertakings.  It  is  not  usual  to  find  the  elements  of 
the  capital  assets  classified  in  sufficient  detail  in  a 
published  balance  sheet.  For  example,  the  land  and 
buildings  may  be  merged  in  one  account,  or  land, 
buildings  and  equipment  may  be  merged  in  one  ac- 
count. Inasmuch  as  the  reader  of  the  balance  sheet 
probably  would  not  be  in  a  position  to  know  the  value 
of  the  land  or  the  building  or  the  equipment,  he  would 
be  at  a  loss  to  decide  whether  or  not  the  amount  of 
capital  invested  in  this  class  of  assets  was  excessive 
or  inadequate.     Neither  would  it  be  possible  for  him 


VALUATION  OF  FIXED  ASSETS  115 

to  determine  satisfactorily  the  adequacy  of  the  re- 
serves provided  for  depreciation. 

In  other  cases,  the  intangible  fixed  capital  of  good- 
will, patent  rights,  copyrights,  trade-marks  or  fran- 
chises may  be  merged  with  the  tangible  fixed  capital. 
In  cases  where  this  occurs  it  is  a  fair  assumption  that 
the  intangible  fixed  capital  constitutes  a  large  pro- 
portion of  the  total  value  of  the  assets.  It  is  to  be 
noted,  however,  that  many  of  the  larger  corporations 
now  follow  the  practice  of  stating  separately,  in  their 
balance  sheets,  the  valuation  of  the  tangible  and  the 
intangible  fixed  assets.  Occasionally  in  public  bal- 
ance sheets  we  find  the  tangible  fixed  capital  grouped 
under  an  account,  "cost  of  property."  However, 
this  is  no  indication  of  its  true  value. 

The  relation  between  total  fixed  assets  and  the  ag- 
gregate amount  of  capital  and  long-term  debt  is  im- 
portant. In  considering  this  relation,  the  reserve 
for  depreciation  may  be  ignored,  for  theoretically  the 
cash  which  represents  this  reserve  is  available  for  the 
repair  of  any  waste  or  decline  in  the  value  of  the  fixed 
tangible  assets  or  it  has  been  reinvested  in  property. 
Many  organizations  make  the  mistake  of  investing  too 
much  of  their  capital  in  costly  plant  and  do  not  leave 
enough  working  capital  with  which  to  conduct  their 
operations  profitably.  It  may  then  be  necessary  for 
them  to  raise  large  amounts  of  floating  debt  with 
which  to  finance  the  purchase  of  working  and  trading 
assets,  pending  the  conversion  of  their  current  assets 
into  cash.     As  pointed  out  in  the  Text  on  "Corpora- 


116     FINANCIAL  AND  BUSINESS  STATEMENTS 

tion  Finance,"  these  floating  liabilities  may  be  a 
source  of  weakness  or  the  cause  of  insolvency  in  times 
of  panic  or  depression. 

If  the  corporation  has  an  issue  of  bonds,  it  is  im- 
portant to  note  just  what  particular  property  of  the 
organization  is  pledged  as  security  for  the  debt.  In 
all  probability,  the  land,  land  improvements,  buildings 
and  structures  are  specifically  pledged.  But  in  this 
connection  it  must  be  remembered  that  much  of  the 
plant  and  machinery  and  building  equipment,  under 
the  law,  is  technically  realty  or  realty  fixtures,  and 
accordingly  may  be  pledged  under  the  mortgage. 

20.  Equipment  purchased  on  the  partial-payment 
plan. — Transportation  companies  and  other  under- 
takings often  acquire  equipment  on  the  partial-pay- 
ment plan.  It  is  evident  that  equipment  purchased 
under  this  method  of  financing  will  cost  more  than  if 
it  were  paid  for  in  cash.  The  difference  between  the 
price  paid  under  the  partial-payment  plan  and  the 
cash  price  of  the  same  equipment  is  the  amount  of  in- 
terest which  the  seller  has  charged  as  an  offset  to  the 
postponement  of  the  payment  date.  Usually  it  will 
not  be  a  difficult  matter  to  determine  what  the  cash 
price  is.  Then,  the  number  of  payments  being  known 
and  a  reasonable  rate  of  interest  assumed,  it  will  be 
possible,  thru  the  medium  of  instalment  loan  tables, 
to  determine  how  much  of  each  periodical  payment  is 
to  be  applied  to  the  reduction  of  the  debt,  and  how 
much  represents  interest. 

The  greater  portion  of  the  initial  payment  will  be 


VALUATION  OF  FIXED  ASSETS  117 

on  account  of  interest,  but  the  gradually  decreasing 
principal  will  decrease  the  interest  charge  correspond- 
ingly, with  the  result  that  the  later  payments  will  re- 
duce the  principal  more  rapidly.  The  agreement  un- 
der which  equipment  is  sold  in  this  way  usually  pro- 
vides that  the  title  shall  remain  in  the  seller  until  after 
a  specified  number  of  rental  payments  have  been 
made.  Then,  upon  the  payment  of  $1.00  additional 
at  the  end  of  the  rental  period,  the  seller  agrees  to 
transfer  title  to  the  purchaser. 

During  the  rental  period,  the  purchaser  will  have  to 
bear  all  the  maintenance  charges  necessary  to  keep  the 
equipment  in  its  original  condition.  It  also  follows 
that  depreciation  enters  into  the  problem,  and  that 
the  buyer  will  have  to  set  aside  out  of  his  earnings  an 
adequate  provision  for  the  accrued  depreciation  on 
the  equipment  which  will  come  ultimately  into  his 
possession.  The  proper  method  of  treating  the 
periodical  instalment  is  to  set  up  in  the  balance  sheet 
as  an  asset  the  amount  paid  each  period  on  account  of 
principal.  This  would  be  designated  by  a  title  such 
as,  "Equity  in  equipment  purchased  under  partial- 
payment  plan,"  or  by  some  other  suitable  and  descrip- 
tive title.  The  balance  of  the  periodical  instalment 
should  be  charged  to  the  income  account. 

Inasmuch  as  the  title  remains  in  the  seller  until  the 
final  payment  is  made,  objection  may  be  raised  to 
this  method  of  treatment.  The  ground  for  the  objec- 
tion would  be  that  the  equity  is  not  an  actual  asset 
and  would  be  forfeited  if  the  purchaser  failed  to  com- 


118     FINANCIAL  AND  BUSINESS  STATEMENTS 

plete  the  remaining  payments.  While  this  is  true, 
yet  if  there  does  not  appear  to  be  any  doubt  of  the 
firm's  ability  to  meet  the  remainder  of  the  payments 
when  due,  it  seems  to  be  better  to  set  up  the  equity 
in  the  balance  sheet. 

Another  method  of  handling  the  matter  would  be 
to  express  the  full  contractual  agreement  in  the  ac- 
counts. This  would  be  done  by  setting  up  an  asset 
account  showing  the  cost  price  of  the  equipment  in 
the  equipment  account,  suitably  ear-marked  by  a  con- 
tra-reference  to  the  total  contractual  liability  due  to 
the  sellers.  The  amount  of  interest  included  in  the 
purchase  price  could  be  set  up  as  a  deferred  charge 
to  income,  and  it  also  should  be  suitably  ear-marked 
by  a  contra-reference  to  the  contractual  liability  set 
up  and  representing  the  amount  due  to  the  seller. 
As  each  periodical  payment  is  made  in  cash,  the  con- 
tractual liability  created  would  be  reduced  and  casli 
credited. 

Furthermore,  at  each  periodical  payment  a  rateable 
proportion  of  the  deferred  charge,  or  the  deferred 
asset,  for  interest  would  be  transferred  to  the  cur- 
rent-income account;  thereby  the  amount  of  the  de- 
ferred asset  is  reduced.  The  amount  standing  at  the 
debit  of  the  equipment  account,  plus  the  amount  of  the 
deferred  charge  to  income  remaining  on  the  books, 
would  represent  the  firm's  equity  in  the  equipment, 
when  offset  by  the  balance  remaining  in  the  contrac- 
tual liability  account. 


VALUATION  OF  FIXED  ASSETS  119 


REVIEW 

State  whether  the  principles  applicable  to  the  valuation  of 
land  differ  according  to  its  uses,  as  plant  land,  as  investment  or 
as  stock  in  trade  of  a  real  estate  development. 

How  do  mining  and  timber  companies  usually  treat  land  in 
their  accounts? 

In  what  important  respect  does  the  valuation  of  buildings 
differ  from  that  of  plant  land? 

Give  reasons  why  the  accounts  should  always  segregate  equip* 
ment  from  lands  and  buildings. 

What  is  the  best  method  by  which  to  treat,  in  the  accounts, 
equipment  purchased  on  the  instalment  plan? 

State  some  of  the  conclusions  which  may  be  drawn  from  the 
manner  in  which  accounts  may  be  grouped  in  the  statement  of 
assets. 


CHAPTER  VIII 

VALUATION  AND  INTERPRETATION  OF 
INTANGIBLE  ASSETS 

1.  Introduction, — It  is  common  practice  to  include 
under  capital,  or  fixed  assets,  such  items  as  good-will, 
patents,  franchises  and  the  like.  Inasmuch  as  all 
assets  of  this  nature  are  of  an  intangible  character, 
as  distinguished  from  real  estate,  buildings,  plants, 
etc.,  the  author  thinks  it  more  advisable  to  group 
them  under  a  separate  heading. 

2.  Good-will  defined. — While  good-will  frequently 
appears  as  an  asset  in  the  balance  sheet  of  a  business 
concern,  there  are  very  few  who  have  a  definite  con- 
ception of  its  true  nature,  or  of  the  proper  method  of 
valuing  it.  Good-will  has  been  denned  as  that  in- 
tangible quality  of  patronage  which  attaches  to  an 
established  business  and  is  presumed  to  attach  to  it, 
irrespective  of  any  change  of  ownership. 

A  better  definition,  perhaps,  would  be  that  good- 
will represents  the  present  worth  or  capitalized  value 
of  the  estimated  future  earnings  of  an  established  en- 
terprise in  excess  of  the  normal  results  that  it  might 
reasonably  be  assumed  would  be  realized  by  a  similar 
undertaking  established  anew. 

Guthrie,  in  discussing  good-will,  says: 

120 


VALUATION  OF  INTANGIBLE  ASSETS       121 

The  measure  of  value,  in  pecuniary  terms,  of  this  intangi- 
ble thing  is  the  difference  between  the  value  of  the  normal 
results  of  the  working  of  any  business  or  profession  which 
may  be  established  by,  and  as  worked  by,  any  person  in  any 
place,  and  the  result  of  working  any  individual  business  of  a 
similar  character.  Thus,  given  a  business,  the  good-will  of 
which  is  for  disposal,  there  would  be  no  valuable  good-will  if 
any  one  could  do  just  as  well  by  establishing  a  business  anew. 
To  start  a  business  has  its  risks,  which  may  often  be  de- 
scribed as  very  serious  risks,  but  apart  from  the  mere  peril- 
ous risks  of  failing  to  take  proper  root,  there  is  the  often 
weary  time- — sometimes  a  long  term  of  years — during  which 
a  sufficient  connection  is  being  got  together  to  bring  the 
business  up  to  a  standard  paying  basis  which  will  give  a 
good-will  value,  or  bring  a  good-will  value  into  sight.  To  be 
spared  this  period  of  what  I  may  call  perilous  probation 
is  something  worth  paying  for,  even  tho  its  maintenance 
from  this  point  needs  the  continuous  energy  and  industry 
by  which  it  was  built  up  by  the  original  proprietor.  Time, 
money  and  anxiety  saved  is  money  made.  This  is  what  is 
worth  paying  for  and  in  this  degree  a  good-will  value  attaches 
to  an  established  business. 

3.  Value  of  good-will  dependent  on  location. — The 
value  of  good-will  is  dependent  on  a  number  of  fac- 
tors. One  of  them  is  the  location  of  the  business 
premises.  A  change  in  the  movement  of  traffic,  due 
to  the  opening  of  a  subway  or  the  relocation  of  a 
terminal,  may  result  in  loss  of  patronage.  This  fre- 
quently happens  in  the  more  populated  centers.  On 
the  other  hand,  it  is  not  unusual  to  find  examples  of 
businesses  so  well  established  as  not  to  be  injured 
materially  by  the  diversion  of  traffic  or  the  inconven- 
ience of  reaching  the  business  premises. 

4.  Good-will  dependent  upon  the  reputation  and 


122     FINANCIAL  AND  BUSINESS  STATEMENTS 

integrity  of  the  firm. — Good- will  may  also  depend 
upon  the  reputation  of  the  firm  for  fair  dealings  and 
integrity.  Thus,  strict  fulfilment  of  contracts,  de- 
pendable quality  of  the  merchandise  sold,  employment 
of  efficient  salespeople,  prompt  deliveries,  favorable 
terms  of  credit,  are  attractive  features  which  result 
in  increased  patronage,  frequently  in  spite  of  an  un- 
favorable location,  or  the  more  extensive  advertising 
of  competitors.  As  long  as  the  original  business 
policies  are  continued,  good-will  of  this  type  usually 
will  not  be  affected  by  a  change  of  ownership.  In 
this  case  good-will  consists  of  the  advantage  which 
the  new  proprietor  derives  from  being  allowed  to 
represent  himself  as  the  successor  of  the  former  owner 
or  owners. 

5.  Good-will  created  by  established  monopolies. — 
Good-will  is  often  created  by  the  monopoly  enjoyed 
thru  the  possession  of  a  patent  right  or  franchise,  or 
as  the  result  of  the  demand  created  and  the  patronage 
procured  thru  the  extensive  advertising  of  a  trade- 
mark. While  the  life  of  a  patent  is  limited  by  law, 
in  many  instances  its  holder  or  holders  may  have  se- 
cured a  foothold  from  which  it  may  be  almost  im- 
possible for  competitors  to  dislodge  them,  even  tho 
the  patent  has  expired. 

In  this  connection  it  is  well  to  bear  in  mind  that 
good-will  has  often  been  used  as  a  subterfuge  to  re- 
duce the  rate  of  return  on  capital  investment.  That 
is  particularly  true  in  the  case  of  public  service  cor- 
porations. 


VALUATION  OF  INTANGIBLE  ASSETS      123 

In  the  litigation  between  the  City  of  New  York  and 
the  Consolidated  Gas  Company  of  that  city,  the 
Supreme  Court  of  the  United  States  rendered  a  de- 
cision to  the  effect  that  in  determining  whether  or 
not  a  legislative  rate  was  reasonable,  good-will  could 
not  be  included  as  an  asset. 

This  decision  points  out  that  there  can  be  no  recog- 
nition of  good-will  in  the  case  of  a  public  service 
monopoly.  In  view  of  the  popularity  of  holding 
companies  the  decision  is  well  worth  remembering  on 
account  of  the  effect  which  the  further  interpretation 
and  enlargement  of  this  doctrine  may  have. 

6.  The  earning  power  as  a  factor  in  the  valuation  of 
good-will. — The  fact  that  a  business  possesses  a  favor- 
able location  and  has  a  well-established  patronage 
does  not  necessarily  imply  that  a  purchaser  should 
be  willing  to  pay  for  its  good-will.  If  these  advan- 
tages do  not  return  in  net  income  a  rate  higher  than 
a  fair  rate  of  interest  on  the  capital  investment  and 
the  wages  of  management,  the  purchaser  would  be 
unwise  to  pay  for  good-will. 

The  new  owner  will  naturally  expect  to  receive  a 
greater  return  of  income  than  his  interest  and  man- 
agement expense,  or  at  least  he  will  desire  to  see 
in  the  business  the  possibilities  of  receiving  greater 
profits  than  his  predecessor  obtained. 

It  is  quite  true  that  the  good-will  of  a  defunct  en- 
terprise has  frequently  realized  a  fairly  large  sum  on 
the  sale  of  the  business,  but  in  these  instances  it  will 
be  found  that  the  new  purchaser  bought  with  the 

XXII— 10 


124     FINANCIAL  AND  BUSINESS  STATEMENTS 

hope  of  being  able  to  overcome  obvious  faults  of  mis- 
management, and  that  he  depended  upon  building  up 
a  successful  and  profitable  enterprise  by  himself. 

In  the  amalgamation  and  consolidation  of  compet- 
ing companies  good-will  is  frequently  represented  by 
the  anticipated  savings  which  it  is  hoped  will  result 
from  the  elimination  of  competition  and  the  introduc- 
tion of  economies  in  management. 

Where  these  anticipated  savings  have  not  been 
realized — and  that  is  true  in  many  cases — usually  it 
will  be  found  that  the  good-will  which  was  created 
was  represented  by  an  issue  of  common  stock  that 
received  no  dividends.  In  that  case  it  is  spoken  of 
as  fictitious  good-will. 

7.  Transferability, — Mention  has  been  made  of  the 
factor  of  transferability.  A  professional  firm  sus- 
tains a  confidential  relation  with  respect  to  its  clients, 
and  it  is  very  difficult  to  separate  the  good-will  of  such 
a  firm  from  the  personality  of  the  professional  man. 
It  may  be  said,  therefore,  that  the  good-will  in  this  in- 
stance, as  a  transferable  asset  of  value,  is  almost  non- 
existent. It  is  for  this  reason  that  courts  in  many 
jurisdictions  refuse  to  recognize  good-will  that  rests 
entirely  upon  individualities,  and  a  purchaser  would 
be  unwise  to  pay  a  high  price  for  it. 

8.  Method  of  valuing. — The  most  common  method 
of  valuing  good-will  is  the  so-called  year's  purchase 
method.  The  good-will  is  valued  upon  the  basis  of 
a  certain  number  of  years'  purchase  of  the  annual 
profits  of  a  selected  number  of  preceding  years,  or  a 


VALUATION  OF  INTANGIBLE  ASSETS       125 

certain  number  of  years'  purchase  of  the  excess  in- 
come of  the  enterprise,  which  consists  of  the  residue 
of  profits  that  remains  after  deducting  interest  on 
the  capital,  wages  of  management,  and  the  like,  from 
the  net  profits  of  operation.  When  this  method  is 
used  it  is  important  to  see  that  the  years  selected  have 
been  normal  ones  and  that  the  results  in  future  years 
are  likely  to  approximate  or  to  exceed  past  experi- 
ence. 

The  number  of  years  to  be  considered  is  a  matter  of 
bargain  between  the  buyer  and  the  seller,  and  accord- 
ingly no  general  rule  can  be  laid  down  to  apply  to  all 
lines  of  business.  The  usual  estimate  for  an  ordinary 
trading  business  is  two  years'  purchase  of  the  profits. 
Where  a  manufacturing  business  is  under  considera- 
tion the  period  is  usually  longer,  say  from  four  to 
five  years,  whereas  for  a  monopoly  or  a  quasi-monop- 
oly  the  period  selected  is  usually  from  eight  to  ten 
years,  and  for  professional  practice  the  period  usually 
selected  is  one  year. 

The  purchase  of  the  profits  for  a  number  of  years 
is  in  reality  the  purchase  of  an  annuity  of  the  amount 
of  the  profits  for  the  number  of  years  selected.  If 
this  view  is  taken,  the  good-will  will  be  valued  by 
the  so-called  annuity  method.  Under  this  theory  the 
good-will  is  assumed  to  have  a  certain  definite  life,  and 
when  the  amount  of  the  excess  profits  and  the  number 
of  years  during  which  they  are  to  be  enjoyed  have 
been  determined,  the  problem  consists  of  determining 
the  present  value  of  the  annuity  for  the  period  selected 


126     FINANCIAL  AND  BUSINESS  STATEMENTS 

at  a  given  rate  per  cent.     This  can  be  ascertained 
readily  from  compound  interest  tables. 

9.  Factors  to  be  eliminated  for  the  purpose  of  val- 
uation.— During  the  period  covering  the  years'  pur- 
chase, if  unusual  transactions  or  speculative  ventures 
were  entered  into  which  resulted  in  extraordinary 
profits,  the  amount  of  these  profits  should  be  elimi- 
nated. Such  profits  are  not  incidental  to  the  busi- 
ness which  it  is  proposed  to  acquire,  and  therefore  they 
should  be  ignored.  The  same  rule  applies  to  any 
other  unusual  or  exceptional  items  of  profit.  Take 
as  an  illustration  the  conditions  resulting  approxi- 
mately from  the  European  war. 

It  often  happens  that  the  owner  of  a  business  an- 
ticipates selling  it,  or  has  been  using  exceptional  econ- 
omy in  expenditures  for  repairs  during  the  last  year 
or  two,  which  would  naturally  reduce  the  amount 
charged  against  profits.  Such  a  practice  not  only  is 
an  ultimate  detriment  to  the  assets  of  the  business, 
but  it  also  results  in  an  overstating  of  the  profits  with 
a  consequent  overvaluation  of  good-will. 

The  amount  of  money  paid  for  interest  on  borrowed 
capital  should  be  eliminated  from  the  expenses,  for 
the  reason  that  interest  on  borrowed  money  is  a  pen- 
alty which  the  business  has  had  to  pay  for  not  having 
sufficient  capital.  The  same  thing  applies  when  a 
firm  has  not  taken  advantage  of  discounts,  by  reason 
of  lack  of  capital  with  which  to  prepay  its  bills. 

10.  Factors  requiring  careful  scrutiny. — It  is 
necessary  to  see  that  adequate  depreciation  has  been 


VALUATION  OF  INTANGIBLE  ASSETS       127 

provided  for,  not  only  on  the  fixed  assets  but  also  on 
some  of  the  current  and  deferred  assets.  The  reader 
will  see  readily  that  if  proper  provision  for  deprecia- 
tion has  not  been  made,  the  profits  will  be  overstated 
and  the  good-will  correspondingly  overvalued. 

In  determining  the  value  of  the  good-will  it  is  im- 
portant to  see  that  all  existing  liabilities  on  contracts 
which  the  former  owner  may  have  entered  into  are 
given  due  consideration.  Contracts  may  have  been 
entered  into  prior  to  the  date  of  the  sale  of  the  busi- 
ness, the  completion  of  which  may  result  in  a  loss  and 
therefore  affect  the  profits  to  be  enjoyed  by  the 
vendee. 

Oftentimes  it  is  found  that  sales  on  consignment  or 
sales  on  approval  have  been  represented  in  the  ac- 
counts as  valid  sales  and  the  full  credit  for  profits 
has  been  taken  into  the  income  account. 

In  other  cases  when  municipal  assessments  are 
allowed  by  law  to  run  for  a  number  of  years,  the 
books  will  not  reflect  these  obligations  in  any  way. 
It  will  be  noted  that  the  annual  payment  of  assess- 
ments of  this  character  will  seriously  affect  the  profits, 
and  if  any  unpaid  assessments  remain,  due  weight 
should  be  given  to  them  in  considering  profits. 

In  some  instances  only  a  portion  of  the  business  is 
disposed  of  by  the  vendor.  It  may  be  that  he  is  to 
retain  that  part  of  the  business  which  is  earning  all 
the  profits,  and  that  he  is  selling  that  portion  which  is 
not  profitable.  If  the  accounts  of  both  branches  have 
been  merged  and  if  it  is  impossible  to  extract  informa- 


128     FINANCIAL  AND  BUSINESS  STATEMENTS 

tion  from  the  records  as  to  the  profitableness  of  the 
individual  units  of  the  business,  the  determination  of 
the  value  of  the  good-will  becomes  a  very  difficult 
problem. 

11.  Mathematical  results. — The  first  step,  there- 
fore, is  to  determine  what  the  annual  profits  are  for 
a  number  of  years.  The  next  step  is  to  average  them 
so  as  to  get  the  average  profit  for  one  year.  It  is 
customary  to  deduct  at  this  point  interest  on  the 
capital  invested  from  the  amount  so  found.  The  in- 
terest rate  is  generally  an  assumed  per  cent  per  an- 
num, often  six  or  seven  per  cent.  This  is  based  on 
the  theorv  that  a  tangible  asset  in  the  business  wTill 
earn  at  least  that  rate  of  interest.  In  other  words, 
out  of  the  total  profits  realized,  this  particular  amount 
is  reserved  for  the  normal  interest  which  the  invested 
capital  would  earn  elsewhere.  The  result  will  be  the 
excess  income,  which  constitutes  an  annuity  to  be  en- 
joyed  for  a  period  of  years. 

12.  Fictitious  good-will. — The  good-will  account  is 
sometimes  used  as  a  medium  for  concealing  losses,  the 
account  being  raised  to  an  amount  equivalent  to  or 
greater  than  the  deficit  in  the  income  account.  It 
may  also  represent  an  overissue  of  capital  stock.  In 
fact,  good-will  appearing  in  the  balance  sheet  of  many 
of  the  largest  consolidations  represents  stocks  and 
even  bonds  issued  not  only  for  all  the  good-will  that 
the  consolidated  concerns  actually  possessed,  but  in 
addition  all  fees  for  banking  and  promotion  services. 
In  a  few  instances  this  account  represents  an  exag- 


VALUATION  OF  INTANGIBLE  ASSETS       129 

gerated  forecast  of  the  savings  and  economies  an- 
ticipated thru  the  consolidation  of  competing  con- 
cerns which  unfortunately  have  never  materialized. 

13.  When  good-will  is  created. — From  an  account- 
ant's point  of  view,  good-will  should  appear  on  finan- 
cial statements  after  it  has  been  acquired,  and  for  the 
original  cost  only. 

It  is  held  by  some  that  when  a  concern  has  just 
commenced  business  and  has  incurred  a  large  expense 
for  advertising  during  the  probation  period,  it  should 
be  charged  to  a  good-will  account.  This  is  based  on 
the  theory  that  it  is  unfair  to  charge  all  the  expense 
of  large  advertising  appropriations  and  the  cost  of 
creating  a  demand  for  the  products  of  the  firm, 
against  the  profits  of  the  year  in  which  the  expenses 
were  incurred.  If  the  expenditures  mentioned  above 
resulted  in  placing  the  business  upon  a  firm  founda- 
tion, and  if  there  is  a  reasonable  assurance  that  profits 
will  result  from  the  expense  incurred  in  promoting 
the  business,  it  is  permissible  to  charge  this  extraordi- 
nary advertising  expense,  during  the  first  two  or  three 
years,  to  a  good-will  account.  This  practice  is  based 
on  the  theory  that  the  amount  has  been  expended  for 
the  benefit  of  subsequent  years,  which  are  to  receive 
the  advantage  of  the  present  extraordinary  expense. 

However,  for  safety's  sake,  it  may  perhaps  be  much 
more  advisable  that  such  expenditures  be  carried  un- 
der "Prepaid  Advertising"  and  be  written  off  in  fu- 
ture years. 

Good-will  should  not  be  created  arbitrarily  upon 


130     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  accounts  of  a  business  except  in  cases  similar  to 
those  mentioned  above. 

Neither  in  the  case  of  a  sole  trader  or  partnership 
nor  in  the  case  of  a  corporation  has  this  practice 
anything  to  commend  it.  An  intending  purchaser 
would  value  the  good-will  independently,  regardless 
of  its  value  in  the  balance  sheet  of  the  vendor.  Bank- 
ers or  credit  men  would  ignore  the  items  and  rather 
view  them  with  suspicion. 

14.  Is  good-will  of  a  fluctuating  value? — While 
good-will  is  an  asset  of  the  most  fixed  nature,  in  the 
sense  that  it  could  not  be  disposed  of  without  seriously 
interfering  with  the  success  of  the  business,  it  is  neces- 
sarily a  fluctuating  asset,  because  its  value  is  meas- 
ured by  the  earning  power  of  the  business,  which  or- 
dinarily fluctuates.  It  must  follow  that  the  value  of 
the  asset  will  correspondingly  fluctuate. 

There  is  considerable  discussion  as  to  whether  or 
not  this  is  true.  In  a  paper  read  before  the  Congress 
of  Accountants — in  St.  Louis,  in  1904 — entitled  "The 
Profits  of  a  Corporation,"  Mr.  A.  L.  Dickinson, 
C.P.A.,  states: 

.  .  .  As  long  as  the  earnings  of  a  business  are  main- 
tained at  not  less  than  the  level  contemplated  at  date  of  pur- 
chase, it  is  impossible  to  allege  any  depreciation  of  value  or 
the  necessity  of  any  provision  therefor.  On  the  other  hand, 
if  any  serious  depreciation  has  taken  place,  the  profits  are 
probably  so  much  reduced  that  it  is  not  possible  to  make 
such  provision.  Good-will  is,  in  fact,  a  fixed  asset  whose 
value  is  to  some  extent  dependent  upon  the  profits,  and  its 
fluctuation  being  consequent  on,  and  not  a  cause  of,  the  earn- 


VALUATION  OF  INTANGIBLE  ASSETS       131 

ings  or  profits,  as  are  wasting  or  partially  wasting  assets, 
should  not,  therefore,  to  be  taken  into  account  in  ascertaining 
them. 

On  the  other  hand,  in  an  article  that  appeared  in 
"The  Accountant"  (London,  December  6th,  1913), 
Mr.  John  Bauer  makes  a  plea  for  an  annual  adjust- 
ment of  the  good-will,  based  upon  the  profits,  and 
advocates  the  adoption  of  the  plan  because  of  certain 
advantages  which  he  claims  will  result  from  it.  He 
distinguishes  fundamentally  between  asset  value 
(cost)  and  capital  value.  He  uses  this  latter  term  to 
represent  the  sum  of  the  discounted  future  profits  of 
the  business,  assuming  equal  annual  profits.  Under 
this  plan  the  good- will  account  would  be  adjusted  an- 
nually thru  the  surplus  account  or  thru  the  proprie- 
torship account,  based  upon  the  showings  of  the  busi- 
ness. If  the  business  looked  highly  prosperous  and 
the  prosperity  seemed  likely  to  increase,  or  at  least 
remain  static,  the  good-will  would  be  increased  and 
the  surplus,  or  proprietorship,  correspondingly  in- 
creased. If,  on  the  other  hand,  the  reverse  were  true, 
both  the  surplus  and  the  good-will  account  would  be 
decreased. 

To  further  support  his  theory  he  cites  the  case  of 
a  concern  with  tangible  or  physical  assets  worth 
$50,000,  which  is  taken  over  by  another  company,  the 
latter  paying  $5,000  for  the  good-will.  On  the  books 
of  the  new  company  the  assets  will  appear  at  a  valua- 
tion of  $55,000,  because  the  second  company  paid 
$50,000  for  tangible  assets  and  an  additional  $5,000 


132     FINANCIAL  AND  BUSINESS  STATEMENTS 

for  the  good-will.  Yet  a  concern  in  all  respects 
similar  to  the  first  mentioned,  but  operating  inde- 
pendently, would  present  a  balance  sheet  with  the 
assets  totaling  only  $50,000.  If  good-will  is  recog- 
nized in  the  first  case,  why  should  it  not  be  recognized 
in  the  second?  Mr.  Bauer's  plan  is  novel  and  inter- 
esting. It  is  doubtful,  however,  whether  it  will  be 
widely  accepted.  As  a  matter  of  fact,  the  principle 
involved  in  Mr.  Bauer's  discussion  is,  whether  or  not 
assets  should  be  valued  at  cost  or  upon  the  basis  of 
present-day  values  irrespective  of  cost.  We  are  of 
the  opinion  that  a  rigid  cost  theory  of  value  is  the  best, 
for  the  reason  that  any  other  theory  may  lead  easily  to 
inaccuracy  and  manipulation,  and  therefore  may  work 
serious  hardship  to  investors. 

15.  Adjustment  of  good-will  account  in  consolida- 
tions.— When  a  company  takes  over  the  assets  of 
other  companies,  numerous  adjustments  on  their 
books  are  necessary,  and  some  of  these  affect  the  good- 
will account.  For  illustration,  let  us  assume  that 
Company  "C"  has  agreed  to  purchase  the  assets  of 
Corporation  "A"  and  also  the  assets  of  Corporation 
"B."  Let  us  assume,  further,  that  the  assets  of  Cor- 
poration "A"  were  purchased  for  an  amount  of  stock 
in  excess  of  the  value  of  the  physical  assets — in  other 
words,  that  something  was  paid  by  "C"  for  the  good- 
will of  "A."  Suppose  further  that  the  assets  of  "B" 
were  acquired  for  an  amount  of  stock  less  than  the 
book  value  of  the  physical  assets.  In  the  latter  case 
the  presumption  may  be  that  the  assets  of  Company 


VALUATION  OF  INTANGIBLE  ASSETS      133 

"B"  were  not  worth  the  book  value.  On  the  other 
hand,  if  Company  "B"  were  not  operating  at  a  profit, 
the  new  or  consolidated  company  might  be  able  to 
purchase  its  assets  for  less  than  their  physical  value. 
If  Corporation  "C"  takes  over  the  assets  of  Company 
"B"  at  their  book  value  a  surplus  will  result,  because 
less  than  the  book  value  was  paid  for  the  assets ;  and  if 
the  assets  of  Company  "B"  were  fairly  worth  the 
value  shown  by  the  books,  the  surplus  would  be  a 
valid  one  and  a  question  arises  as  to  the  disposition  to 
be  made  of  it. 

From  a  legal  standpoint  there  can  be  no  objection 
to  such  a  surplus  being  made  available  for  dividends. 
Conservative  practice,  however,  would  favor  the  use  of 
the  surplus  for  the  purpose  of  reducing  the  good-will 
account  on  "C's"  books.  Now,  in  the  books  of  Cor- 
poration "C"  the  good-will  will  appear  at  a  value 
equivalent  to  the  amount  paid  for  "A's"  good- will,  re- 
duced by  the  surplus  resulting  from  the  acquisition  of 
"B's"  assets.  On  the  same  principle,  any  increase  in 
the  revaluation  of  the  tangible  assets  at  the  time  of  the 
purchase  may  well  be  applied  to  the  reduction  of  the 
good-will  account  on  the  books  of  the  consolidated 
company. 

16.  Good-will  in  consolidated  balance  sheet. — The 
good-will  account  in  a  consolidated  balance  sheet  will 
represent  not  only  the  aggregate  of  the  good-will  ac- 
counts in  the  balance  sheets  of  the  subsidiary  compa- 
nies, but  in  addition  it  will  represent  the  amount  by 
which  the  aggregate  value  of  the  stock  of  the  sub- 


134     FINANCIAL  AND  BUSINESS  STATEMENTS 

sidiaries  on  the  books  of  the  holding  company  exceeds 
the  par  value  of  their  stock  and  surplus,  on  the  date 
of  the  acquisition  of  the  stock  of  the  subsidiaries. 
For  example,  if  the  stock  of  one  of  the  subsidiary  com- 
panies appears  on  the  books  of  the  holding  company 
at  a  value  of  $120  per  share,  and  if  the  book  value 
of  the  stock  on  the  date  of  acquisition  were  $110  per 
share,  the  difference  of  $10  per  share  in  the  cost  of  the 
securities  to  the  holding  company,  and  their  book 
value  at  the  date  the  stock  was  acquired,  would  have 
to  be  adjusted  thru  the  good-will  account  on  the  con- 
solidated balance  sheet. 

17.  Patents,  trade-marks  and  copyrights. — In  con- 
sidering the  valuation  of  good-will,  it  is  well  to  bear 
in  mind  the  valuation  to  be  placed  upon  such  assets 
as  patents,  trade-marks  or  copyrights,  because  the 
rights  conveyed  by  these  grants  create  a  monopoly  in 
favor  of  the  owner  or  owners.  In  turn,  quite  com- 
monly a  good-will  is  created  which,  as  a  rule,  will  last 
a  longer  period  than  the  legal  life  of  the  assets.  This 
is  because  the  owner  of  the  grants  during  the  years 
in  which  he  enjoys  a  monopoly  has  so  firmly  en- 
trenched himself  that  competitors  will  not  easily  suc- 
ceed in  dislodging  him.  It  has  already  been  explained 
that  a  patent  is  a  grant  which  the  Government  makes 
to  an  inventor,  conveying  and  securing  to  him  the 
exclusive  right  to  make  and  sell  his  invention  for 
a  limited  number  of  years.  In  the  United  States  the 
life  of  a  patent  is  seventeen  years  and  the  grant  may 
be  renewed  only  by  special  act  of  Congress.     While 


VALUATION  OF  INTANGIBLE  ASSETS       135 

in  this  country  it  is  not  necessary  to  use  the  patent 
right  in  order  to  retain  the  grant,  in  certain  foreign 
countries  this  is  not  the  case. 

A  trade-mark  is  a  grant  by  the  government  whereby 
a  certain  design,  slogan  or  particular  label  or  device 
is  reserved  to  the  holder  of  the  grant,  as  his  exclusive 
trade-mark,  and  he  is  protected  against  its  use  by 
others.  In  the  case  of  trade-marks,  however,  the 
owner  or  owners  must  use  the  design  or  label  in  order 
to  be  protected  in  it,  and  it  is  to  be  noted  that  the 
rule  is  different  in  this  case  from  that  of  a  patent. 
The  grant  has  a  life  of  thirty  years,  and  is  renewable 
for  a  like  period. 

A  copyright  is  a  right  conveying  the  exclusive  priv- 
ilege of  printing,  publishing  or  vending  copies  of 
certain  artistic  or  literary  productions.  A  copyright 
has  a  life  of  twenty-eight  years  from  the  date  on 
which  it  is  recorded  and  it  is  renewable  for  a  similar 
period  under  certain  conditions. 

18.  Valuation  of  patents. — If  a  patent  has  been 
purchased  from  the  inventor,  or  from  a  former  owner, 
the  question  of  valuation  is  a  simple  one.  The  valua- 
tion of  the  patent  is  the  price  which  the  owner  has 
paid  for  it,  and  this  value  must  be  amortized,  at  least 
during  the  remaining  years  of  its  legal  life.  As  a 
matter  of  conservative  practice  it  is  best  to  write  off 
the  patent  at  less  than  the  legal  life,  because  of  the 
fact  that  new  inventions  will  generally  render  the 
patent  valueless  before  the  expiration  of  its  legal  life. 
Another  method  of  writing  off  a  patent  right  is  to 


! 


136     FINANCIAL  AND  BUSINESS  STATEMENTS 

predetermine,  as  closely  as  possible,  the  number  of 
units  to  be  produced  under  the  grant  and  charge  the 
unit  cost  of  each  article  produced  with  a  proportion- 
ate part  of  the  value  assigned  to  the  patent,  so  that  the 
cost  of  the  patent  will  be  spread  over  the  units  pro- 
duced under  the  grant. 

Many  business  concerns  maintain  engineering  de- 
partments which  produce  valuable  inventions  from 
time  to  time,  and  if  any  of  them  are  patented  it  is  con- 
sidered proper  to  charge  the  patent  account  with  the 
cost  of  conducting  the  experiments  and  investigations 
which  led  to  the  production  of  the  inventions.  In  ad- 
dition to  this  all  fees  paid  in  connection  with  the  reg- 
istration are  also  chargeable  to  the  patent  account. 
It  may  be  necessary  for  the  owner  of  the  patent  to  en- 
gage in  lawsuits  in  order  to  protect  his  rights  and 
prosecute  infringements.  If  these  suits  are  success- 
ful there  is  no  serious  objection  to  charging  their 
cost,  if  it  is  not  collectible,  against  this  patent 
account. 

19.  Valuation  of  trade-marks. — While  the  actual 
cost  of  securing  the  trade-mark  is  insignificant,  its 
value  may  be  very  great.  Inasmuch  as  the  life  of  a 
trade-mark  is  limited  to  the  actual  number  of  years 
during  which  it  is  to  be  used,  it  is  difficult  to  predeter- 
mine the  approximate  life  of  the  asset.  When  a 
trade-mark  has  been  purchased  from  others  and  the 
cost  of  acquiring  it  has  been  high,  it  must  be  assumed 
that  the  trade-mark  carries  with  it  a  certain  amount 
of  good- will.     The  same  general  principles  which  have 


VALUATION  OF  INTANGIBLE  ASSETS      137 

been  discussed  in  the  preceding  sections  apply  to 
trade-marks. 

20.  Valuation  of  copyrights. — The  value  of  a  copy- 
right usually  lasts  for  a  shorter  period  than  the  legal 
life,  a  fact  which  adds  to  the  difficulty  of  valuing  it 
properly.  When  a  copyright  is  obtained  by  a  com- 
poser or  an  author  the  cost  is  insignificant.  In  such 
cases  it  is  usual  to  write  off  the  amount  as  a  part  of 
the  expense  of  the  first  edition  of  the  work. 

Copyrights  may  be  purchased  from  a  former  owner, 
and  in  such  cases  a  high  price  is  often  paid  for  them. 
It  is  then  usual  for  the  amount  paid  to  be  spread 
over  a  number  of  years,  during  which  it  is  expected 
the  public  favor  will  be  retained.  These  factors  are 
so  difficult  of  determination  that  conservative  prac- 
tice requires  that  this  asset  be  written  off  rapidly.  It 
will  be  noticed  that  the  life  of  patents,  copyrights 
and  trade-marks  is  terminable  by  law,  whereas,  that  of 
good-will  is  not. 

Patents,  copyrights  and  trade-marks,  as  balance 
sheet  items,  are  frequently  used  as  devices  to  conceal 
issues  of  watered  stock,  and  when  the  amount  ap- 
pears relatively  large  a  question  is  raised  at  once  as 
to  the  correctness  of  the  valuation.  In  this  connec- 
tion, however,  it  must  be  borne  in  mind  that  the 
good-will  is  often  built  up  around  a  patent,  a  copy- 
right or  a  trade-mark.  Therefore,  while  the  legal 
life  of  the  asset  may  have  terminated,  the  good-will 
created  as  a  result  of  the  continuous  use  of  the  monop- 
olistic grant  may  have  become  very  valuable. 


138     FINANCIAL  AND  BUSINESS  STATEMENTS 

In  the  discussion  of  the  intangible  assets  the  au- 
thor has  assumed  that  the  statements  showing  these 
assets  have  been  compiled  from  books  that  have  been 
kept  honestly.  It  is  the  part  of  wisdom,  however,  for 
a  prospective  purchaser  to  employ  a  competent  ac- 
countant for  the  purpose  of  verifying  the  results  of  op- 
eration and  the  valuation  of  the  assets.  To  safeguard 
himself  it  is  best  to  procure  a  certificate  as  to  profits 
and  valuation  of  assets. 

REVIEW 

Define  good-will,  and  state  the  factors  upon  which  it  depends 
and  the  means  by  which  it  is  created. 

What  factors  must  be  taken  into  consideration  in  valuing  good- 
will?    What   should   be   disregarded? 

Describe  the  method  of  reaching  a  reasonable  valuation  for 
good-will.  What  are  the  motives  which  prompt  an  inflation  of 
this  account? 

What  is  the  proper  treatment  of  good-will  in  making  con- 
solidated balance  sheets   for  a  corporation  and  its  subsidiaries? 

Can  rules  be  formulated  for  the  valuation  of  patent  rights, 
trade-marks  and  copyrights? 

Why  is  conservatism  especially  needed  here? 


CHAPTER  IX 

VALUATION  AND  INTERPRETATION  OF 
CURRENT  ASSETS 

1.  Current  assets  defined, — The  reader  will  recall 
that  current  assets  mean  assets  available  for  the  pur- 
pose of  discharging  current  liabilities.  Included  un- 
der this  heading  are  such  items  as  cash  on  hand  and 
in  bank,  notes  receivable,  accounts  receivable,  and  all 
other  debts  due  to  the  business,  having  a  maturity  date 
of  less  than  one  year. 

2.  Cash  on  hand. — The  cash  balance  in  the  hands 
of  petty  cashiers,  or  working  funds  in  the  hands  of 
employes,  form  the  cash  on  hand.  Cash  items  or 
I.  O.  U.'s  should  not  be  included  as  a  part  of  cash. 
These  funds  are  usually  handled  under  the  imprest 
cash  system,  which  has  been  described  fully  in  the 
volume  on  "Accounting  Principles." 

3.  Cash  in  bank. — Cash  in  bank  may  consist  of 
amounts  on  deposit  subject  to  immediate  check,  or  it 
may  be  represented  by  certificates  of  deposit  which 
may  not  be  withdrawn  until  a  certain  number  of  days 
after  notice. 

Certificates  of  deposit  which  may  not  be  withdrawn 
until  a  certain  number  of  days  after  notice  should 
not  appear  in  a  balance  sheet,  unless  they  are  suit- 

139 
XXII— 11 


140     FINANCIAL  AND  BUSINESS  STATEMENTS 

ably  ear-marked  to  indicate  the  restricted  character 
of  the  balances. 

It  occasionally  happens  that  a  firm  will  overdraw 
its  bank  account  by  sending  out  checks  for  a  greater 
amount  than  it  has  on  deposit,  relying  on  a  suffi- 
cient amount  of  collections  to  make  good  its  balance 
before  the  checks  are  presented  at  the  bank.  If  the 
cash  is  overdrawn  at  the  date  of  the  balance  sheet, 
the  fact  should  be  disclosed  by  setting  up  a  current 
liability  for  the  amount  of  the  overdraft. 

Some  large  corporations  have  considerable  sums 
of  cash  on  hand  which  it  may  not  be  wise  to  place 
in  temporary  investments,  or  which  may  not  be  in- 
vested safely  in  merchandise  purchases.  Occasion- 
ally portions  of  the  cash  fund  may  not  draw  inter- 
est. It  is  advisable  to  state  separately  in  the 
balance  sheet,  or  in  a  sub-schedule  to  a  balance  sheet, 
the  amount  of  cash  balances  which  are  not  drawing 
interest. 

When  a  concern  sells  securities  with  the  under- 
standing that  the  proceeds  are  to  be  used  for  special 
purposes,  the  proceeds  of  such  sales  should  not  be 
merged  with  cash  funds  which  are  subject  to  check. 
Thus,  an  organization  might  sell  some  of  its  preferred 
stock  for  the  purpose  of  financing  the  construction 
of  an  addition  to  its  plant.  Conditions  may  have 
changed  in  the  meantime  so  that  it  is  not  considered 
desirable  to  proceed  with  the  construction  work.  The 
corporation  is  under  a  moral  obligation  at  least  to 
keep  the  proceeds  of  the  sale  of  such  stock  separate 


VALUATION  OF  CURRENT  ASSETS  141 

from  its  cash  subject  to  check.     It  should  not  use  the 
funds  for  other  purposes. 

Cash  deposited  with  sinking-fund  trustees  should 
not  be  shown  as  a  current  asset,  because  the  amounts 
are  not  available  for  the  general  purposes  of  the  or- 
ganization. 

4.  Investments  in  stocks  and  bonds. — Investments 
in  securities  may  be  either  permanent  or  temporary. 
Permanent  investments  may  be  investments  made  for 
the  purpose  of  controlling  the  activities  of  another 
organization,  or  they  may  be  fund  investments  of  re- 
serves. Temporary  investments  may  be  illustrated 
by  such  cases  as  occur  when  a  corporation  has  large 
cash  resources  and  cannot  invest  them  profitably  in 
merchandise  or  obtain  a  reasonable  rate  of  interest 
from  depositories.  In  this  event,  the  firm  may  pur- 
chase securities  for  the  purpose  of  obtaining  a  larger 
income,  but  with  the  idea  of  being  able  to  convert  the 
securities  into  cash  when  additional  cash  funds  are 
required. 

5.  Classification  of  permanent  investments. — Per- 
manent investments  may  be  classified  broadly  as  fol- 
lows: 

(1)  Investments  in  the  stocks  and  bonds  of  parent 

companies. 

(2)  Investments  in  the  stocks  and  bonds  of  sub- 

sidiary companies. 

(3)  Investments  in  the  stocks  and  bonds  of  allied 

companies. 


142     FINANCIAL  AND  BUSINESS  STATEMENTS 

(4)   Investments  in  the  stocks  and  bonds  of  out- 
side companies. 

A  further  subdivision  might  be  made  as  between 
those  which  are  pledged  and  those  which  are  not 
pledged.  A  corporation  may  pledge  its  holdings  of 
stocks  and  bonds  as  security  for  its  issue  of  collateral 
trust  notes  or  bonds.  If  any  of  the  investments  of  a 
corporation  have  been  pledged  for  this  purpose,  the 
balance  sheet  should  disclose  that  fact. 

The  first  and  second  classifications  have  already 
been  treated  fully  in  previous  chapters. 

6.  Investments  in  the  stocks  of  allied  companies. — 
Investments  frequently  occur  in  the  stock  of  allied 
companies.  Examples  of  this  type  are:  the  invest- 
ment which  a  railroad  company  makes  in  the  stock  of 
an  express  company  operating  over  its  lines;  or  in- 
vestments in  stocks  of  terminal  companies  and  de- 
velopment projects.  Such  investments  should  be  car- 
ried at  cost.  Conservative  management  requires  that 
appreciation  in  the  investment  should  be  ignored  un- 
til the  time  of  sale,  while  depreciation  in  the  value  of 
the  investment  should  be  provided  for  thru  the  medium 
of  an  appropriate  reserve. 

7.  Investments  in  outside  companies. — Outside 
investments  are  frequently  made  out  of  surplus  cash 
funds  for  the  purpose  of  realizing  a  higher  rate  of 
return  than  could  be  secured  from  bank  deposits.  In 
the  majority  of  cases,  these  are  intended  to  be  sold 
as  soon  as  the  business  needs  cash.     Consequently, 


VALUATION  OF  CURRENT  ASSETS  143 

they  will  be  treated  usually  as  current  assets  if  they 
are  purchased  with  the  intention  of  making  them 
available  for  cash  requirements.  When  the  invest- 
ments are  purchased  for  temporary  purposes,  it  is 
necessarily  implied  that  a  change  in  the  value  of  se- 
curities will  have  a  more  direct  effect  upon  the  bal- 
ance sheet  of  the  company  than  a  change  in  the  value 
of  permanent  investments.  While  the  general  rule 
that  investments  should  be  carried  at  cost  is  a  safe 
one  to  apply  even  in  this  case,  due  attention  should  be 
given  to  a  reserve  for  any  possible  loss  in  value  thru 
a  decline  in  the  market  price  of  such  securities. 

8.  Investments  of  insurance  companies  and  invest- 
ment companies. — Fire  insurance  companies,  life  in- 
surance companies  and  investment  companies  fre- 
quently are  required  by  law  to  value  their  invest- 
ments for  balance  sheet  purposes  in  accordance  with 
the  ruling  market  prices  on  the  date  of  the  balance 
sheet.  When  an  organization  is  compelled  to  adopt 
this  plan  for  its  statements,  it  is  deemed  advisable  to 
place  the  cost  of  the  securities  to  the  owner  in  a 
parenthetical  reference  on  the  balance  sheet,  so  that 
comparison  may  be  made  between  the  cost  and  the 
present  market  value  of  securities. 

9.  Investments  of  bankers  and  brokers. — Bankers 
and  brokers  holding  investments  in  stocks  and  bonds 
are  accustomed  to  value  the  securities  held  by  them 
at  the  market  price  on  the  date  of  closing  the  books. 
It  often  happens  in  these  cases  that  some  securities 
on  hand  will  have  increased  in  market  value,  while 


144     FINANCIAL  AND  BUSINESS  STATEMENTS 

others  will  show  a  loss.,  owing  to  the  decline  in  mar- 
ket value.  It  is  considered  proper  in  the  case  of 
bankers  or  brokers  to  allow  the  increases  to  offset  the 
decreases  and  to  take  any  increase  in  the  market  value 
of  securities  to  the  credit  of  profit  and  loss,  setting 
aside  a  reserve  for  any  loss  sustained  on  the  decline 
in  market  value  at  the  date  of  the  balance  sheet. 

10.  Treatment  of  outside  investments  in  bonds  dif- 
ferent trom  that  of  investment  in  stocks. — The  prin- 
cipal differences  between  stocks  and  bonds  have  been 
pointed  out  in  the  volume  on  ''Corporation  Finance," 
and  it  remains  for  us  now  to  consider  the  accounting 
features  with  respect  to  bonds.  It  is  evident  that  if  a 
bond  has  been  purchased  at  a  premium  and  is  to  be 
held  until  its  maturity,  a  smaller  sum  than  the  pur- 
chase price  will  be  realized  on  the  maturity  date.  The 
premium  paid  at  the  time  of  the  purchase  should  be 
written  off  against  the  income  received  from  the  bond 
during  its  life,  so  that  each  year's  income  will  be 
credited  only  with  the  true  yield  on  the  investment. 

For  example,  if  the  nominal  rate  of  interest  on  a 
bond  is  5  per  cent,  and  if  the  bond  sells  at  a  premium, 
the  actual  yield  on  the  bond  will  be  a  much  lower 
rate  of  interest. 

Assuming  that  a  corporation  purchased  8100,000 
worth  of  bonds  bearing  interest  at  5  per  cent,  payable 
semi-annually,  with  rive  years  to  run  before  maturity. 
and  that  the  premium  paid  amounted  to  $1,000,  the 
owner  must  amortize  the  premium  during  the  five 
rears  that  the  bonds  have  to  run.     Altho  he  receives 


VALUATION  OF  CURRENT  ASSETS         145 

for  interest,  at  the  semi-annual  period,  the  sum  of 
$2,500,  his  actual  income  on  the  bonds  is  only  $2,400, 
and  he  should  deduct  the  sum  of  $100  from  the  in- 
terest received  at  each  period.  The  effective  rate 
of  interest  in  this  case  would  be  only  4.8  per  cent,  in- 
stead of  5  per  cent.  By  reason  of  the  premium  paid, 
there  has  been  a  loss  of  0.2  in  the  interest. 

On  the  other  hand,  it  is  obvious  that  if  bonds  are 
purchased  at  a  discount,  the  yield  is  higher.  To 
carry  out  our  former  illustration,  if  the  $100,000 
worth  of  bonds  were  bought  at  $99,000,  the  yield 
would  be  5.05  per  cent. 

11.  Securities  purchased  for  speculation, — Stocks 
and  bonds  are  sometimes  purchased  on  margins,  for 
speculation.  In  this  case,  the  assets  consist  of  the 
right  to  receive  the  delivery  of  the  securities  upon  the 
payment  of  the  balance  of  the  purchase  price.  An 
offset  to  this  asset  is  the  liability  due  to  the  broker 
for  the  full  purchase  price,  less  the  margin  deposited. 
Subject  to  the  qualifications  mentioned  with  regard 
to  investment  companies  whose  practice  is  to  value 
securities  for  balance  sheet  purposes  at  the  market 
price,  securities  purchased  on  margins  should  be  car- 
ried at  cost,  plus  the  brokers'  fees  incidental  to  the 
purchase. 

The  interest  charged  by  the  broker  for  the  differ- 
ence between  the  amount  deposited  as  margin  and 
the  purchase  price,  should  be  charged  to  the  security 
account  and  credited  to  the  broker's  account.  There 
will  be  an  offset  for  the  credit  for  interest  allowed  by 


146     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  broker  on  the  amount  deposited  as  margin.  Any 
dividends  received  on  stocks,  or  interest  received  on 
bonds  by  the  broker  for  the  account  of  the  investor, 
will  be  charged  to  the  account  of  the  broker  and 
credited  either  to  the  investment  account  or  to  the 
income  account,  preferably  the  former.  The  differ- 
ence between  the  asset  and  the  liability  account  will 
measure  the  equity  of  the  owner  in  the  investment. 

It  is  often  better  to  credit  to  the  asset  account  divi- 
dends and  interest  received,  reducing  the  cost  of  the 
investment  so  that  when  the  investment  is  eventually 
sold,  the  proprietor  will  be  enabled  to  determine  his 
net  profit  or  loss  on  the  speculative  transaction,  tak- 
ing into  consideration  all  the  elements  that  have  en- 
tered into  it. 

12.  Investments  in  the  stocks  of  mining  companies. 
— It  has  already  been  pointed  out  that  in  the  case  of 
mining  companies  it  is  not  customary  to  set  aside  a 
reserve  for  the  depreciation  of  wasting  assets.  Divi- 
dends declared  on  the  stocks  of  such  companies  are 
in  part  a  return  of  the  capital  invested  and  in  part 
a  return  of  income.  In  the  case  of  a  coal-mining 
property,  the  investor  might  be  able  to  secure  infor- 
mation which  would  enable  him  to  apportion  approxi- 
mately the  amount  of  the  dividend  received  on  the 
stock  as  between  the  part  of  it  which  was  a  return 
of  the  capital  investment  and  the  part  which  consti- 
tuted true  income.  But  in  gold-mining,  copper-min- 
ing companies  and  oil  companies  it  is  not  possible 
to  do  this,  and  hence  the  necessity  of  following  a  care- 


VALUATION  OF  CURRENT  ASSETS  147 

ful  and  conservative  policy  with  investments  of  this 
character. 

Investments  in  the  stocks  of  timber  companies  may 
have  a  somewhat  different  character,  because  such 
companies  are  often  in  the  habit  of  setting  aside  re- 
serves for  depletion  or  exhaustion.  Often  the  re- 
serve set  aside  is  reinvested  in  additional  timber  prop- 
erties or  in  the  reforestation  of  the  denuded  land. 
The  policy  of  the  particular  company  in  these  mat- 
ters will  determine  the  treatment  to  be  given  in  the 
accounts  to  income  received  on  such  stocks. 

Investors  in  the  bonds  of  companies  whose  assets 
are  of  wasting  character  are  usually  protected  by  the 
accumulation  of  a  sinking  fund. 

13.  General  considerations  with  reference  to  valua- 
tion of  securities, — It  is  always  well,  whenever  possi- 
ble, to  check  investments  of  this  character  against  the 
current  market  prices.  When  this  cannot  be  done  the 
cost  prices  of  the  investments  should  be  obtained,  if 
the  investments  are  carried  in  the  balance  sheet  on 
any  other  basis.  Bonds  must  be  considered  with  ref- 
erence to  security  of  principal  and  with  regard  to  the 
ability  of  the  obligor  to  meet  the  interest  payments. 
In  connection  with  foreign  investments  the  possibili- 
ties of  profit  or  loss  due  to  fluctuations  in  exchange 
should  be  considered. 

14.  Notes  receivable. — We  must  distinguish  be- 
tween notes  which  are  taken  in  the  ordinary  course 
of  trade  and  those  which  are  given  to  an  organiza- 
tion for  its  accommodation.     Each  class  should  be 


148     FINANCIAL  AND  BUSINESS  STATEMENTS 

stated  separately  on  a  balance  sheet.  Notes  which 
have  been  given  by  officers,  directors,  stockholders  or 
partners  should  not  be  included  in  the  notes  receiv- 
able from  trade  debtors.  The  reason  for  this  will  be 
evident  if  we  reflect  that  one  who  reads  the  balance 
sheet  will  assume  ordinarily  that  the  notes  and  ac- 
counts receivable  represent  amounts  not  collected  from 
trade  debtors,  unless  otherwise  stated.  It  is  evident 
that  notes  given  to  a  merchant  for  his  accommodation 
or  notes  from  officers,  directors  or  stockholders  are 
not  taken  in  the  ordinary  course  of  business,  and  a 
balance  sheet  which  did  not  disclose  the  true  char- 
acter of  these  transactions  would  be  misleading.  As- 
sets of  this  character  are  probably  not  as  liquid  as 
notes  from  trade  debtors,  or  they  might  not  be  avail- 
able for  the  purpose  of  meeting  current  liabilities. 
The  fact  that  notes  are  marked  "demand  notes"  is 
not  necessarily  an  indication  that  the  debtor  would 
be  able  to  pay  on  demand. 

Any  notes  receivable  which  have  been  assigned  or 
pledged  as  collateral  security  for  a  loan  should  be 
handled  in  the  same  manner  as  merchandise  pledged 
as  security  for  advances.  It  may  not  be  inadvisable 
to  point  out  here  that  the  fact  that  a  business  organ- 
ization is  compelled  to  assign  its  notes  or  accounts  re- 
ceivable is  not  necessarily  an  indication  of  a  poor 
financial  standing.  The  establishment  of  bank  credit 
is  not  always  an  easy  matter. 

Notes  receivable  having  more  than  one  year  to  run 
should  not  be  included  under  current  assets. 


VALUATION  OF  CURRENT  ASSETS  149 

The  value  of  notes  receivable  depends  upon  the 
solvency  of  the  maker.  When  the  maker  of  a  note 
fails  to  pay  it  at  maturity  and  asks  frequently  for  an 
extension  of  time  or  for  a  renewal  of  the  note,  the 
holder  may  well  be  on  his  guard  against  the  con- 
tingency that  the  amount  due  may  not  be  recovered. 
It  is  desirable  to  insist  that  notes  taken  from  custom- 
ers be  payable  at  the  customer's  bank  rather  than 
at  the  place  of  business  of  the  creditor.  The  reason 
for  this  is  that  the  failure  of  the  maker  to  pay  his 
note  will  be  called  to  the  attention  of  his  local  bank. 
Rather  than  have  this  happen,  the  maker  may  be  more 
diligent  in  finding  the  means  to  pay  the  debt  when 
due  than  he  would  if  the  note  were  payable  at  the  of- 
fice of  the  creditor. 

15.  Trade  debtors. — The  amounts  due  from  trade 
debtors  are  classified  as  those  which  are  good,  doubt- 
ful, or  bad.  By  the  term,  "good  accounts,"  we  un- 
derstand amounts  due  from  trade  debtors  which  are 
not  due  as  yet  under  the  terms  of  sale,  and  about 
which  there  seems  to  be  no  doubt  of  ultimate  realiza- 
tion. "Doubtful  accounts"  are  amounts  due  from 
trade  debtors  who  either  have  not  paid  promptly  or 
about  whom  certain  information  has  come  to  hand 
which  makes  it  appear  doubtful  whether  the  full 
amount  eventually  will  be  realized.  The  term  "bad 
accounts"  includes  those  sums  due  from  trade  debtors 
who  failed  to  pay  after  the  ordinary  means  of  collec- 
tion had  been  resorted  to,  or  whose  affairs  are  in  the 
hands  of  assignees  or  receivers. 


150     FINANCIAL  AND  BUSINESS  STATEMENTS 

The  question  of  the  valuation  of  accounts  receiv- 
able due  from  trade  debtors  often  will  present  a  num- 
ber of  difficulties.  The  debtors  may  be  temporarily 
short  of  funds,  owing  to  poor  business  conditions  or 
failure  of  banks  in  their  vicinity  to  extend  prompt 
and  reasonable  accommodations.  In  certain  sections 
of  the  country,  it  is  customary  for  customers  to  ex- 
pect long  terms  of  credit.  Therefore,  the  length  of 
time  that  an  account  is  overdue,  is  not  a  necessary  in- 
dication that  the  amount  due  will  not  be  realized 
ultimately.  Moreover,  the  amount  being  overdue 
may  not  be  entirely  the  fault  of  the  debtor.  Lax  col- 
lection methods  and  failure  to  render  statements  prop- 
erly, are  sometimes  the  cause  of  slow  payments. 

While  the  method  of  "aging"  accounts  is  an  ad- 
mirable one  to  use  in  attempting  to  find  out  the 
real  value  of  the  amount  due  from  trade  debtors,  it 
is  not  possible  to  use  this  method  in  all  cases.  Oc- 
casionally when  a  debtor  becomes  irregular  in  his 
payments,  the  credit  man  will  secure  a  pledge  of  col- 
lateral of  some  kind  to  protect  his  firm  against  loss. 

For  example,  if  the  amount  due  at  the  end  of  the 
fiscal  period  is  considerably  in  excess  of  the  amount 
due  at  the  beginning,  the  account  may  be  open  to 
suspicion.  Notes  charged  back  to  the  account  of  the 
debtor  are  an  indication  that  would  put  one  on  guard. 
Checks  originally  given  by  a  debtor  and  returned 
by  the  bank,  marked  "no  funds"  is  another  sign. 
We  must  consider  also  the  circumstances  and  gen- 
eral financial  conditions  in  the  country  or  in  the  par- 


VALUATION  OF  CURRENT  ASSETS         151 

ticular  section  of  the  country  in  which  the  debtor's 
business  is  located.  Thus,  for  example,  during  the 
year  1915,  conditions  in  the  South  were  rather  se- 
rious, owing  to  the  inability  of  the  planters  to  market 
their  crops  advantageously.  Business  firms  generally 
complained  that  they  were  not  receiving  the  proper 
accommodations  from  their  banks.  It  is  a  well 
known  fact  that  many  business  houses  in  the  North 
were  financing  their  Southern  customers  at  that  par- 
ticular time. 

This  condition,  however,  was  only  temporary  and 
while  it  accounted  for  the  large  increase  in  the  amounts 
due  from  trade  debtors  in  many  of  the  balance  sheets 
prepared  at  the  end  of  the  year  1915,  the  situation 
in  1916  was  very  different.  In  fact,  many  merchants 
in  the  North  reported  that  concerns  in  the  South  to 
whom  they  had  extended  accommodations  or  to  whom 
long  dating  had  been  given  in  prior  years,  were  tak- 
ing up  their  notes  and  even  discounting  invoices 
within  ten  days.  This  fact  is  mentioned  merely  to  in- 
dicate that  all  the  surrounding  conditions  and  circum- 
stances must  be  carefully  weighed  in  placing  a  value 
upon  the  amount  due  from  trade  debtors. 

16.  Treatment  of  bad  accounts. — Even  where  the 
account  of  a  trade  debtor  seems  to  be  bad,  the  amount 
should  not  be  written  off  the  ledger  until  the  final 
discharge  of  the  debtor  in  bankruptcy  or  the  return 
of  an  unsatisfied  execution.  The  reason  for  this  is 
that,  pending  final  adjustment  in  bankruptcy,  the 
amount  should  be  left  open  on  the  ledger  to  call  the 


152     FINANCIAL  AND  BUSINESS  STATEMENTS 

attention  of  the  proper  persons  to  the  fact  that  the 
amount  is  still  due.  Moreover,  dividends  are  very 
often  subsequently  received  from  accounts  which  have 
been  considered  bad,  and  if  the  amount  has  been  writ- 
ten off  entirely,  dishonest  cashiers  have  been  known 
to  appropriate  these  sums  to  their  own  uses. 

17.  Treatment  of  miscellaneous  accounts  receiv- 
able.— Amounts  due  from  stockholders  for  subscrip- 
tions to  stock,  amounts  due  from  officers  or  employes 
for  loans  or  amounts  due  from  partners  in  a  partner- 
ship, should  be  stated  separately  on  the  balance  sheet. 
If  any  portion  of  these  amounts  is  not  likely  to  be 
recovered,  appropriate  reserves  should  be  provided. 

18.  Interest  on  notes  or  accounts  receivable. — 
When  notes,  open  accounts,  or  advances  draw  inter- 
est by  their  terms  it  should  be  accrued  up  to  the  date  of 
the  balance  sheet.  The  amount  of  interest  accrued  is 
to  be  shown  under  the  heading  of  current  assets  and 
it  is  a  proper  credit  to  income.  However,  this  state- 
ment needs  to  be  qualified  because  it  is  clear  that  it 
would  be  improper  to  credit  to  income  accruing  in- 
terest on  doubtful  debts  or  notes  receivable.  While 
it  may  be  desirable  to  accrue  the  interest  for  the  pur- 
pose of  showing  the  total  amount  due  from  the  doubt- 
ful debtor,  the  amount  of  interest  added  to  the  doubt- 
ful debt  should  not  be  credited  to  the  income  account. 
It  should  be  carried  to  the  credit  of  the  reserve  pre- 
viously created  to  measure  the  anticipated  loss  on 
realization  of  the  principal  sum  due. 

19.  Different  methods  of  providing  for  the  reserve 


VALUATION  OF  CURRENT  ASSETS  153 

for  bad  and  doubtful  debts. — Some  provide  for  the 
reserve  for  doubtful  debts  on  the  basis  of  a  certain 
percentage  of  the  sales.  If  the  firm  has  experience 
of  past  years  upon  which  it  may  rely,  this  may  be 
the  proper  and  conservative  method  of  providing  for 
this  reserve.  It  has  an  advantage  in  that  it  sets  aside 
insurance  for  bad  and  doubtful  debts  out  of  the  rev- 
enue received  during  the  same  period.  The  certain 
percentage  is  charged  against  profit  and  loss  and 
credited  to  a  specially  ear-marked  reserve  account, 
and  if  debts  become  bad  or  doubtful,  the  amounts  are 
charged  against  the  reserve.  While  the  reserve  may 
accumulate  and  perhaps  be  larger  in  amount  than  is 
apparently  necessary,  yet  it  must  be  remembered  that 
we  have  recurrent  periods  of  dull  times  or  panics 
during  which  the  percentage  of  failures  and  losses 
from  bad  and  doubtful  debts  is  much  greater  than 
usual  and  no  great  harm  seems  to  result  in  allowing 
the  reserve  to  accumulate,  provided  the  amount  is  not 
unreasonably  large. 

Another  method  is  to  charge  a  certain  per  cent  of 
the  outstanding  accounts  based  upon  past  experience 
as  a  reserve  for  doubtful  debts. 

The  third  method  is  to  provide  for  those  accounts 
which  when  "aged"  seem  to  be  actually  bad  or  doubt- 
ful. The  process  under  this  method  is  to  go  thru 
all  the  accounts  that  are  open  on  the  ledger  and  list 
them,  showing  those  which  are  overdue  thirty,  sixty, 
ninety  or  more  days.  A  reserve  is  set  aside  based 
upon  the  results  obtained,  which  is  estimated  to  be  suf- 


154     FINANCIAL  AND  BUSINESS  STATEMENTS 

ficient  to  take  care  of  the  losses.  The  disadvantage  of 
this  method  is  that  the  annual  charges  against  the 
income  account  for  bad  debts  are  liable  to  fluctuate. 
A  large  amount  must  be  provided  in  one  year  and  a 
comparatively  small  amount  in  another  year.  Fur- 
thermore debts  which  apparently  are  good  at  the  date 
of  preparing  the  balance  sheet  may  prove  doubtful 
later  and  no  reserve  will  have  been  provided  for  such 
a  contingency  out  of  the  profit  of  the  period  during 
which  the  accounts  were  created. 

REVIEW 

State  how  cash  in  hand  is  distinguished  from  cash  in  bank. 
Cite  cases  in  which  cash  actually  held  should  not  figure  in  the 
general  cash  account. 

Under  what  circumstances  should  investments  be  valued  at 
cost,  and  what  circumstances  justify  a  departure  from  this  rule? 

What  distinctions  should  be  made  in  notes  receivable  as  to 
the  source  from  which  they  were  obtained?     Why? 

How  should  accounts  receivable  be  classified  for  financial  state- 
ments ? 

Explain  methods  of  handling  a  reserve  for  bad  or  doubtful 

debts. 


CHAPTER  X 

VALUATION  AND  INTERPRETATION  OF 
ASSETS   (Continued) 

1.  Inventories, — The  inventories  of  a  business  un- 
dertaking are  usually  shown  in  a  separate  group  on 
the  balance  sheet,  under  the  caption  of  either  "inven- 
tories" or  "working  and  trading  assets."  Included 
in  this  group  would  be  the  merchandise  which  a  trad- 
ing concern  had  on  hand  at  the  close  of  the  period.  In 
the  case  of  a  manufacturer  it  also  includes  the  stock  of 
raw  material,  partly  finished  goods,  finished  parts  and 
purchased  and  finished  stock.  Occasionally  under 
this  caption  will  be  included  the  inventories  of  post- 
age, advertising  material  and  prepaid  expenses,  such 
as  prepayments  for  advertising,  insurance  and  inter- 
est. 

In  some  published  balance  sheets,  accrued  interest 
on  notes  and  accounts  receivable  is  included.  It  is 
better  perhaps  to  treat  unexpired  insurance  premiums 
under  the  caption  "deferred  charges  to  operations." 
The  accruals  of  interest  in  favor  of  a  business  con- 
cern should  be  included  under  the  group  of  current 
assets;  prepayments  of  interest  on  discounted  notes 
or  other  obligations  should  also  appear  under  the 
group  "deferred  charges  to  operations." 

155 

XXII— 12 


156     FINANCIAL  AND  BUSINESS  STATEMENTS 

2.  Valuation  of  the  inventory  of  a  trading  con- 
cern.— The  merchandise  stock  of  a  trading  concern 
should  be  valued  at  the  cost  laid  down  in  the  ware- 
house or  store  of  the  concern.  It  is  proper  also  to 
add  a  rateable  proportion  of  the  expenses  incurred  in 
the  delivery  of  the  merchandise  to  the  storehouse,  as 
well  as  cartage  and  carrying  charges.  On  imported 
goods,  the  proportion  of  freight,  marine  insurance 
and  duties  applicable  to  the  stock  as  yet  unsold,  may 
be  carried  as  an  asset. 

3.  Should  inventories  be  carried  at  cost  or  at  mar- 
ket price? — Many  authorities  state  that  inventories 
should  be  carried  at  cost  or  at  market  price,  whichever 
value  is  the  lower.  While  perhaps  this  may  be  con- 
servative practice,  the  fact  must  not  be  lost  sight  of, 
that  profits  are  not  made,  nor  are  losses  sustained, 
while  goods  are  on  the  shelves.  It  is  obvious  that  a 
merchant  should  not  carry  his  inventory  at  market 
prices  if  they  are  greater  than  cost,  because  to  do  so 
would  be  to  anticipate  a  profit  which  eventually  might 
not  be  realized.  Moreover,  the  current  period  would 
receive  the  benefit  of  the  inflation  at  the  expense  of 
the  succeeding  period,  and  the  profit  of  the  current 
period  would  consist  not  only  of  the  profit  on  mer- 
chandise actually  sold,  but  also  of  the  profit  taken  up 
thru  the  inflation  of  the  inventory. 

When,  however,  the  market  price  is  lower  than  cost, 
the  same  principle  might  be  applied.  The  loss  will 
not  be  realized  until  the  title  to  the  goods  has  been 
transferred  to  a  customer,  and  the  loss,  since  it  will 


VALUATION  OF  CURRENT  ASSETS  157 

only  occur  at  that  time,  should  be  faced  in  the  period 
in  which  it  takes  place.  Conservative  accounting 
practice,  however,  forces  us  to  make  provision  in  ad- 
vance for  expected  losses.  While  it  would  not  be  ad- 
visable to  change  the  value  of  the  inventory,  a  pro- 
vision might  be  made  in  it  for  the  loss  which  is 
expected  to  be  realized  in  the  succeeding  period,  thru 
the  medium  of  a  reserve  created  after  the  profit  on 
trading  operations  for  the  current  period  has  been 
ascertained. 

4.  Raw  material  inventories  of  manufacturing  con- 
cerns.— Inventories  of  raw  materials  should  be  valued 
at  cost,  plus  the  cost  of  getting  the  goods  into  the 
factory. 

In  some  instances,  due  to  careless  buying,  large 
stocks  of  raw  material  may  have  been  acquired  at  un- 
favorable prices.  There  is,  of  course,  a  tendency  for 
the  selling  price  of  finished  goods  to  follow  closely  the 
fluctuation  in  the  market  for  raw  materials  from 
which  they  are  made.  Thus,  if  a  wire  manufacturing 
company  acquired  a  large  stock  of  20-cent  copper, 
and  wire  was  selling  on  a  13-cent  base,  conservative 
practice  would  dictate  the  creation  of  a  suitable  re- 
serve for  losses  which  it  is  clear  will  ultimately  be 
sustained  on  the  later  sale  of  the  manufactured  prod- 
uct. 

Indirect  materials  or  supplies,  such  as  fuel,  lubri- 
cating oils  and  packing  material  are  subject  to  the 
same  rules  of  valuation  as  direct  materials. 

5.  Work  in  progress. — The  valuation  of  work  in 


158     FINANCIAL  AND  BUSINESS  STATEMENTS 

progress  is  not  usually  a  difficult  matter  when  the 
concern  is  maintaining  an  adequate  cost  system.  If, 
however,  no  cost  system  is  employed,  the  valuation 
of  work  in  progress  is  a  very  difficult  matter.  The- 
oretically, the  work  in  progress  should  be  valued  at 
the  cost  of  the  raw  material  and  the  direct  labor  that 
has  entered  into  it,  plus  a  rateable  proportion  of  the 
manufacturing  overhead,  which  has  been  consumed  in 
the  processing  of  the  material.  There  are  some  au- 
thorities who  object  to  the  inclusion  of  the  rateable 
proportion  of  the  manufacturing  overhead  in  the  in- 
ventory valuation  on  the  ground  that  this  involves 
the  capitalization  of  expense  items.  While  this  is 
true,  we  must  remember  that  the  inventory  is  being 
valued  on  the  basis  of  the  undertaking  as  a  going  con- 
cern. In  order  to  prepare  income  accounts  that  will 
reflect  the  true  profits  of  the  undertaking  as  a  going 
concern,  it  will  be  necessary  to  include  the  rateable 
proportion  of  overhead  expense. 

6.  Finished  goods  stock  should  be  valued  at  manu^ 
facturing  cost. — The  valuation  of  finished  material 
should  be  on  the  basis  of  the  actual  cost  laid  down  in 
the  finished  stock  storeroom.  Many  business  under- 
takings carry  large  stocks  of  finished  parts  as  well  as 
completed  articles.  Thus,  in  a  concern  manufac- 
turing complicated  machinery  with  interchangeable 
parts,  there  would  be  on  hand  at  any  inventory  date, 
not  only  finished  and  completed  machines,  but  also 
a  large  stock  of  interchangeable  parts.  Such  por- 
tion  of  the  administrative   expense   as   is   properly 


VALUATION  OF  CURRENT  ASSETS  159 

chargeable  to  the  finished  stock  may  be  included  in 
the  inventory  valuation. 

It  therefore  follows,  that  goods  which  are  unsea- 
sonable, out  of  fashion,  or  which  are  in  a  shop  worn 
condition,  should  not  be  valued  at  cost  under  any 
circumstances,  but  at  a  price  not  greater  than  that 
which  they  may  be  expected  to  realize  on  sale. 

The  principles  to  be  employed  in  the  valuation  of 
inventories  of  branches  have  been  discussed  in  the 
Text  on  "Accounting  Practice"  in  the  chapter  on 
"Branch  Accounts." 

7.  Treatment  of  merchandise  pledged  as  collateral 
for  loans. — Merchandise  is  frequently  pledged  as  col- 
lateral security  for  loans.  It  is  important  that  the 
value  of  merchandise  so  pledged  shall  be  set  up  sep- 
arately in  the  balance  sheet,  or  at  least  that  a  paren- 
thetical reference  be  made  in  the  balance  sheet  in 
respect  to  it.  In  setting  up  the  liability  for  the 
money  advanced  to  the  undertaking,  there  should  be 
a  contra-reference  to  the  asset  side  showing  the 
amount  due  to  creditors  whose  claims  are  secured  in 
this  manner. 

8.  Possible  deductions  from  inventory  valuations. 
— In  interpreting  the  balance  sheet  of  a  business,  the 
inventory  plays  an  important  part.  One  who  reads 
the  balance  sheet  should  consider  the  inventory  on 
hand  in  connection  with  the  sales  made  during  the 
period.  There  should  be  also  taken  into  considera- 
tion, in  the  case  of  a  manufacturing  concern,  the 
length  of  time  which  it  takes  to  process  raw  material 


160     FINANCIAL  AND  BUSINESS  STATEMENTS 

into  finished  wares.  Thus,  for  example,  if  the  an- 
nual sales  of  an  organization  amounted  to  $1,200,000, 
and  if  it  is  known  that  the  process  of  manufacture 
takes  from  fifteen  to  twenty  days,  while  the  balance 
sheet  discloses  an  inventory  of  $500,000,  one  must  con- 
clude that  the  valuation  of  the  inventorv  has  been  in- 
flated,  that  considerable  dead  stock  is  included  in  it  or 
that  poor  judgment  has  been  used  in  allowing  such  a 
large  stock  to  be  accumulated. 

Even  when  an  inventory  increase  seems  reasonable, 
with  reference  to  the  increase  in  payables  or  the  de- 
crease in  cash,  a  further  investigation  is  sometimes 
necessary.  It  may  be  that  a  great  amount  of  the  in- 
crease will  be  due  to  the  increased  quantities  of  raw 
material  on  hand.  It  might  happen  that  the  con- 
cern was  in  a  position  to  take  advantage  of  favorable 
market  conditions  and  purchase  a  year's  supply  of 
raw  materials.  Thus,  a  miller  might  purchase  large 
stocks  of  wheat  which  he  is  in  a  position  either  to  dis- 
pose of  as  wheat  or  to  manufacture  into  flour.  A 
silk  manufacturer  might  buy  large  quantities  of  raw 
silk  in  a  favorable  market.  During  the  European 
wTar,  a  number  of  electrical  contractors  purchased 
large  stocks  of  raw  copper,  which  they  disposed  of  at 
considerable  profit.  Wholesale  drug  and  chemical 
houses  largely  increased  their  stocks  at  the  beginning 
of  the  European  war  and  sold  them  later,  realizing 
very  much  more  than  the  usual  margin  of  profit. 
These  factors,  therefore,  must  be  given  consideration 
before  determining  whether  or  not  the  inventory  is 


VALUATION  OF  CURRENT  ASSETS         161 

greater  than  the  requirements  of  the  business,  or  be- 
fore coming  to  a  conclusion  that  the  management  has 
exercised  poor  judgment. 

9.  Interpretation  of  current  assets. — The  aggre- 
gate of  the  current  assets  in  a  balance  sheet  should 
be  compared  with  the  amount  shown  in  the  current 
liabilities.  A  concern  may  have  an  excess  of  assets 
over  liabilities  and  still  be  forced  into  insolvency. 
Legal  insolvency  is  the  state  of  being  unable  to  meet 
maturing  liabilities  with  the  assets  on  hand.  Bankers 
like  to  see  the  ratio  of  from  2  to  1  to  4  to  1  between 
the  current  assets  and  the  current  liabilities.  On  the 
other  hand,  judgment  must  be  used  in  making  this 
comparison.  A  firm  may  have  invested  very  heavily 
in  a  stock  of  raw  materials,  and  in  order  to  take  ad- 
vantage of  the  liberal  cash  discount  allowed,  it  has 
seriously  depleted  the  cash  account.  Consequently, 
the  desirable  ratio  of  2  to  1  may  not  exist. 

Current  assets  are  the  source  of  dividend  disburse- 
ments or  withdrawals  of  profits,  and  if  an  undertak- 
ing cannot  safely  reduce  its  liquid  assets  for  this  pur- 
pose, the  distribution  of  profits  should  be  postponed. 
While  a  corporation  that  has  earned  profits  may  bor- 
row the  money  necessary  to  pay  a  dividend,  it  is  ques- 
tionable whether  or  not  such  methods  should  be  re- 
sorted to. 

10.  Importance  of  right  relation  between  current 
liabilities  and  current  assets. — If  the  business  is  of  a 
seasonal  nature,  the  ideal  relation  between  current  lia- 
bilities and  current  assets  cannot  exist.     Thus,  for 


162     FINANCIAL  AND  BUSINESS  STATEMENTS 

example,  the  firm  might  be  acquiring  large  stocks  of 
raw  materials,  partly  finished  goods  and  finished  goods 
to  sell  in  the  following  season.  These  amounts  would 
appear  as  inventories  or  as  working  and  trading  as- 
sets, but  the  liabilities  therefore  would  be  included 
under  the  current  liabilities.  Hence,  the  current  lia- 
bilities would  be  increasing  in  amount,  while  the  fin- 
ished stocks  on  hand  would  not  be  converted  into  ac- 
counts receivable  until  a  later  date,  because  deliveries 
of  manufactured  goods  could  not  be  made  until  the 
approach  of  the  season.  For  example,  in  the  fur 
garment  industry,  there  would  be  a  tendency  for  the 
current  liabilities  to  increase,  beginning  with  the  first 
of  March  and  extending  into  July.  The  current  as- 
sets will  also  decrease,  and  the  inventories  will  in- 
crease. As  soon,  however,  as  deliveries  are  made,  the 
inventories  are  changed  into  current  receivables,  and 
the  normal  relations  which  the  credit  man  or  banker 
likes  to  see  between  current  assets  and  current  lia- 
bilities would  then  be  brought  about. 

This  fact  must  also  be  taken  into  consideration  in 
attempting  to  determine  the  turnover  of  accounts  re- 
ceivable. The  volume  of  sales  may  vary  from  month 
to  month,  and  the  ratio  existing  between  current  as- 
sets and  current  liabilities  will  very  often  depend  upon 
the  peculiar  conditions  and  circumstances  surround- 
ing the  particular  business. 


VALUATION  OF  CURRENT  ASSETS         163 


REVIEW 

State  arguments  against  valuing  goods  in  the  inventories  at 
their  market  price.  What  rule  is  to  be  followed  in  the  case  of 
goods  in  process  of  manufacture,  and  finished  goods  in  a  man- 
ufacturing concern? 

What  significance  is  usually  attached  to  a  conspicious  inventory 
increase?  Under  what  circumstances  would  the  usual  judgment 
be  erroneous? 

How  does  the  contractor  handle  the  problem  of  equalizing 
the  record  of  income  from  month  to  month? 

Describe  how  manufacturers  seek  to  protect  themselves  against 
loss  by  speculative  trading  in  raw  materials. 

What  is  considered  the  standard  ratio  of  current  liabilities  and 
current  assets?  Does  departure  from  this  standard  necessarily 
mean  poor  business  management? 


CHAPTER  XI 

VALUATION  AND  INTERPRETATION  OF 
DEFERRED  ASSETS 

1.  Meaning  of  deferred  assets. — In  order  that  a 
firm  may  be  able  to  determine  the  actual  expenses 
incurred  during  a  period,  it  is  necessary  that  all  ex- 
penses applicable  to  that  period  shall  be  charged  to 
the  income  account.  Similarly,  if  a  firm  has  incurred 
liabilities  or  paid  out  cash  for  items  of  expense,  the 
benefit  or  a  portion  of  the  benefit  of  which  will  be 
enjoyed  in  succeeding  periods,  it  is  fair  that  only  that 
portion  which  applies  to  the  current  period  should 
be  charged  to  this  period.  Therefore,  in  preparing 
the  account  of  a  going  concern,  expenditures  which 
have  been  made  for  the  benefit  of  later  periods  are 
treated  as  assets  and  known  as  deferred  assets.  These 
assets  are  also  called  sometimes  prepaid  items  or  pre- 
payments. 

It  is  desirable  to  point  out  that  it  is  not  always 
necessary  that  a  cash  payment  should  have  been  made 
for  such  items.  For  example,  insurance  may  have 
been  effected  on  the  twenty-sixth  of  December  for 
the  period  of  one  year  and  the  amount  of  the  premium 
may  not  have  been  paid  in  cash  at  all.  The  liability, 
however,  should  be  taken  out  in  the  account  and  the 

164 


VALUATION  OF  DEFERRED  ASSETS        165 

premium  expense  should  be  apportioned  as  between 
the  closing  and  the  succeeding  year;  that  is  on  the 
assumption  that  the  organization  is  closing  its  books 
at  the  end  of  the  calendar  year. 

2.  Organization  expenses. — There  are  a  number 
of  expenses  incident  to  the  organization  of  a  corpora- 
tion, such  as  the  incorporation  fees,  filing  fees,  legal 
expenses,  expenditures  of  promoters  and  many  ex- 
penses in  connection  with  the  issue  of  securities.  It 
would  be  proper  to  charge  to  this  account  all  the  cost 
incurred  in  the  sale  of  stock,  printing  of  the  certifi- 
cates, etc.,  but  not  expenses  in  connection  with  the 
issue  of  bonds.  This  class  of  expenditures  requires 
an  entirely  different  treatment. 

As  the  organization  expenses  will  have  to  be  in- 
curred only  once  during  the  life  of  the  corporation, 
and  as  the  benefit  of  these  expenses  is  presumed  to 
exist  thruout  the  life  of  the  business,  it  is  manifestly 
not  proper  to  charge  them  against  the  operating  rev- 
enue of  the  first  year.  On  the  other  hand,  it  is  deemed 
advisable  to  write  off  the  amount  within  a  reasonable 
period,  depending  somewhat  upon  the  amount  of  the 
initial  expenditures.  The  usual  term  varies  from 
three  to  ten  years. 

While  it  would  probably  be  better  practice  to  per- 
mit an  assessment  of  stockholders  to  such  an  amount 
as  would  be  necessary  to  pay  all  these  expenses,  or 
sell  the  capital  stock  at  such  a  premium  as  would  en- 
able the  premium  to  be  applied  to  the  reduction  of 
these  expenses,  as  is  customary  in  some  countries  of 


166     FINANCIAL  AND  BUSINESS  STATEMENTS 

Europe,  it  is  doubtful  if  the  practice  will  ever  be 
adopted  here.  Usually,  it  is  very  difficult  for  an  in- 
dustrial corporation  in  this  country  to  sell  its  stock  at 
par  without  giving  a  bonus  of  some  sort,  let  alone 
realizing  the  premium  for  it,  or  organizing  it  under  a 
plan  whereby  an  assessment  to  cover  organization  ex- 
penses would  be  permitted. 

3.  Discount  on  the  sale  of  capital  stock. — The 
laws  of  many  states  do  not  permit  a  corporation  to 
issue  its  capital  stock  at  a  discount.  As  is  pointed 
out  in  the  discussion  on  treasury  stock,  the  same  ef- 
fect is  produced  by  a  manipulation  of  treasury  stock 
in  those  states  which  do  not  permit  capital  stock  to  be 
issued  at  a  discount.  Where,  however,  the  law  per- 
mits it,  the  discount  allowed  on  the  par  of  capital 
stock  should  be  charged  to  a  special  account  and  it 
may  be  treated  as  a  deferred  charge  to  expense,  or 
as  a  deferred  asset.  It  should  never  be  merged  with 
the  organization  expense. 

In  its  last  analysis,  the  issue  of  stock  at  a  discount 
is  really  the  same  thing  as  issuing  stock  only  partly 
paid.  Hence,  before  any  dividends  are  distributed 
to  the  stockholders,  the  amount  of  the  discount  al- 
lowed on  the  original  issue  of  capital  stock,  should 
be  wiped  out  thru  the  surplus.  The  stockholders 
who  acquire  stock  issued  at  a  discount  are,  for  prac- 
tical purposes,  in  the  same  status  as  stockholders  who 
acquire  only  partly  paid  stock.  While  a  dividend 
may  be  declared  to  the  stockholders  out  of  current 
profits  earned,  it  is  advisable  that  out  of  the  initial 


VALUATION  OF  DEFERRED  ASSETS        167 

dividends,  an  amount  should  be  retained  by  the  com- 
pany to  wipe  out  the  discount  account. 

4.  Discounts  allowed  on  issue  of  bonds. — Mention 
was  made  in  a  previous  section  that  it  was  improper 
to  charge  discount  on  bonded  obligations  to  the  or- 
ganization expense  account.  The  reason  for  this  is 
that  discount  on  the  bonds  is  really  an  adjustment  of 
the  interest  rate  specified  in  the  evidence  of  debt  to 
the  market  rate  of  interest  for  obligations  of  similar 
character.  For  example,  if  a  corporation  issues  bonds 
bearing  interest  at  the  rate  of  say  5  per  cent  and  the 
market  rate  of  interest  for  securities  of  a  similar 
character  is  6  per  cent,  it  is  obvious  that  the  bonds 
must  be  issued  as  a  discount.  Conversely,  if  bonds 
bearing  interest  at  6  per  cent  are  issued  when  the 
market  rate  for  a  debt  of  a  similar  character  is  o1/^ 
per  cent,  the  bonds  undoubtedly  can  be  sold  at  a  pre- 
mium. It  follows  from  this  that  if  a  corporation  is- 
sues bonds  at  a  discount,  the  effective  rate  of  interest 
which  it  pays,  would  be  the  sum  of  the  annual  interest, 
specified  in  the  bonds,  as  increased  by  a  rateable  pro- 
portion of  the  discount  sustained,  or  as  decreased  by  a 
rateable  proportion  of  the  premium  realized. 

The  unamortized  discount  on  bonds  issued  at  the 
date  of  any  balance  sheet,  is  treated  as  a  deferred  as- 
set, inasmuch  as  it  is  part  of  the  cost  of  financing  and 
the  burden  of  financing  should  be  distributed  over 
the  years  during  which  the  use  of  the  borrowed  funds 
is  to  be  enjoyed. 

In  the  past  it  was  the  usual  practice  when  bond 


168     FINANCIAL  AND  BUSINESS  STATEMENTS 

issues  were  floated  for  the  purpose  of  financing  the 
construction  or  acquisition  of  permanent  assets,  to 
charge  the  amount  of  the  discount  to  the  asset  ac- 
count. In  its  ultimate  analysis,  it  will  be  seen  that 
as  far  as  the  income  account  is  concerned,  this  prac- 
tice is  exactly  the  same  as  carrying  the  amount  of 
the  discount  as  a  deferred  asset.  If  charged  to  con- 
struction, assuming  that  the  life  of  the  asset  is  co- 
incident with  that  of  the  bond,  the  corporation  will 
be  under  the  necessity  of  increasing  the  amount  to 
be  provided  for  depreciation  by  the  amount  of  the 
bond  discount  charged  to  capital  account.  As  a  re- 
sult, the  same  amount  of  discount  would  be  written 
off  each  year,  only  with  this  difference;  that  if  the 
discount  had  been  charged  to  capital,  the  proportion 
written  off  would  appear  as  a  depreciation  charge, 
whereas  if  it  is  carried  as  a  deferred  asset,  it  will 
be  shown  as  an  increase  in  the  cost  of  carrying  the 
debt.  Since  the  purpose  of  accounting  is  to  show 
facts  in  connection  with  the  business  in  their  true  as- 
pect, it  is  evident  that  there  can  be  but  one  logical 
treatment  of  bond  discount,  and  that  is  as  an  item 
of  interest  or  as  a  part  of  the  cost  of  financing,  to 
be  considered  in  connection  with  the  actual  interest 
paid  in  cash  each  year. 

5.  Methods  of  disposing  of  the  bond  discount. — 
Probably  the  method  that  is  most  common  in  prac- 
tice and  at  the  same  time  the  most  convenient,  is  that 
of  writing  off  the  discount  on  bond  issues  equally 
over  the  years  during  which  the  bonds  are  to  run. 


VALUATION  OF  DEFERRED  ASSETS        169 

Thus,  if  the  bonds  have  a  life  of  twenty  years,  one- 
twentieth  of  the  amount  of  discount  sustained,  would 
be  charged  to  the  income  account  each  year.  This 
is  sometimes  called  the  equal  instalment  method,  and 
while  not  the  most  scientific,  it  is  the  easiest  to  apply. 

If  a  corporation  has  a  surplus,  it  may  charge  the 
entire  amount  of  the  discount  to  surplus.  In  this 
event,  however,  the  income  account  of  the  current 
year,  should  be  charged  with  its  rateable  proportion 
of  the  expense  of  borrowed  funds,  and  only  the  bal- 
ance should  be  charged  against  surplus.  This  method 
is  objectionable  on  the  ground  that  it  charges  the 
cost  of  the  borrowed  funds  against  the  surplus  of 
prior  years,  instead  of  against  the  income  during  those 
years  in  which  the  use  of  the  money  is  to  be  enjoyed. 

Another  method  of  disposing  of  the  discount  is  to 
write  off  each  year  the  proportion  of  the  discount 
that  the  sum  of  the  bonds  redeemed  in  any  vear  bears 
to  the  total  amount  of  the  bonds  outstanding. 

The  effective  interest  method  is  the  most  scientific 
and  it  takes  into  consideration  the  amount  of  the  dis- 
count, the  redemption  charges,  and  the  nominal  rate 
of  interest  specified  in  the  bonds.  The  effective  rate 
of  interest  is  the  amount  which  is  charged  to  the  in- 
come account  each  year.  A  pro  rata  portion  of  the 
charge  is  credited  to  the  bond  discount  account,  while 
the  balance  is  credited  to  the  interest  payable  ac- 
count. The  effective  rate  of  interest  can  be  cal- 
culated by  the  use  of  an  annuity  table.  This  rate 
should  be  charged  to  the  income  account  and  the  dif- 


170    FINANCIAL  AND  BUSINESS  STATEMENTS 

ference  between  the  effective  rate  and  the  amount 
of  actual  interest  payable  in  cash,  should  be  credited 
to  unamortized  discount  on  bonds. 

6.  Treatment  of  premiums  on  bonds. — Where 
bonds  are  sold  at  a  premium,  the  procedure  is  the 
reverse  of  that  where  they  are  sold  at  a  discount.  In 
this  case,  a  rateable  proportion  of  the  premium  ac- 
count is  to  be  credited  each  year  to  the  income  ac- 
count. This  is  done  by  debiting  the  premium  on 
bonds,  which  is  a  deferred  liability  or  a  deferred  credit, 
to  income  in  the  balance  sheet,  and  crediting  either 
the  interest  expense  account  or  a  specially  ear-marked 
account  in  the  income  statement.  Where  bonds  are 
sold  at  a  premium,  the  effective  rate  of  interest  paid 
by  the  business  is  less  than  the  nominal  rate. 

7.  Other  examples  of  deferred  assets. — The  doc- 
trine applied  to  deferred  assets  just  mentioned  is 
readily  applicable  to  prepayment  of  rent,  interest, 
taxes  and  other  items  of  expense.  Any  portion  may 
properly  be  capitalized  which  applies  to  the  succeed- 
ing periods  and  which,  from  the  point  of  view  of  a 
growing  concern,  is  recoverable  in  benefit  of  service. 

Considerable  discussion  has  arisen  over  the  tem- 
porary capitalization  of  the  expense  of  national  ad- 
vertising. A  national  advertising  campaign  for  the 
introduction  of  any  product  is  usually  an  expensive 
undertaking.  The  benefit  may  not  be  reflected  im- 
mediately and  as  a  rule  it  is  not,  but  it  is  assumed 
that  it  will  be  realized  in  the  future.  In  this  con- 
nection, it  must  be  considered  that  a  large  initial 


VALUATION  OF  DEFERRED  ASSETS        171 

expense  is  not  the  only  cost,  but  that  a  liberal  ad- 
vertising appropriation  probably  will  have  to  be  made 
in  each  succeeding  year.  The  capitalization  of  ex- 
penditures of  this  kind  requires  careful  considera- 
tion of  all  facts.  It  is  usually  unwise  to  treat  this 
as  an  asset.  The  value  of  advertising  is  not  ques- 
tioned, but  the  results  of  it  will  be  expressed  in  in- 
creased income,  and  in  the  development  of  good-will. 
As  the  reader  has  already  noted,  the  creation  of  good- 
will as  an  asset  is  not  to  be  justified  except  when  it 
is  actually  purchased.  While  the  expenditure  for 
national  advertising  campaigns  may  possibly  be 
summed  up  broadly  in  the  nature  of  a  purchase  of 
good-will,  there  is  a  difference  in  that  it  is  impossible 
to  predetermine  the  value  of  it  as  the  benefits  to  be 
derived  in  the  future,  and  its  valuation  is  not  made  on 
the  basis  of  past  earnings. 

It  is  impossible  to  lay  down  a  general  rule  for 
the  valuation  of  this  asset  that  would  apply  to  all 
cases.  The  capitalization  of  a  portion  of  this  ex- 
pense for  a  short  period  is  justified.  This  is  only 
true  if  one  may  reasonably  expect  that  the  adver- 
tising campaign  has  been  carried  on  judiciously  and 
if  the  returns  seem  to  indicate  that  there  is  a  tendency 
for  new  business  to  increase  in  volume. 

In  any  event,  the  amount  treated  as  an  asset  should 
be  set  forth  clearly  under  a  special  section  in  the  bal- 
ance sheet,  so  as  to  indicate  its  true  character. 

One  must  clearly  distinguish  between  the  expenses 
discussed  in  the  preceding  paragraphs  and  those  which 

XXII— 13 


172     FINANCIAL  AND  BUSINESS  STATEMENTS 

are  made  for  the  direct  benefit  of  the  next  season's 
sales.  Thus,  advertising  literature,  expense  of  ad- 
vertising, or  promotion  expense  for  sales  of  mer- 
chandise to  be  sold  during  the  next  season,  may 
properly  be  capitalized,  so  that  the  amount  may  be 
charged  against  the  income  from  sales  in  the  proper 
period. 

REVIEW 

Explain  the  general  nature  of  a  deferred  asset.  State  the 
best  method  of  handling  the  organization  expenses  of  a  corpora- 
tion, the  discount  on  the  sale  of  capital  stock,  and  outlays  for 
national  advertising. 

Describe  different  methods  of  treating  the  discount  on  bonds 
sold,  and  conversely  the  premium  obtained,  and  state  the  merits 
and  defects  of  each. 


CHAPTER  XII 

TREASURY  STOCK  AND  ITS  TREATMENT 

1.  Treasury  stock  defined. — Treasury  stock  is  that 
stock  of  a  corporation  which  has  once  been  issued 
for  value  and  which  subsequently  has  been  reacquired 
thru  purchase  or  thru  donation  or  in  exchange  for  a 
debt.  The  term  "treasury  stock"  is  frequently  mis- 
used in  place  of  unsubscribed  stock  or  unissued  stock. 
Treasury  stock  as  denned  above,  is  an  asset  and  rep- 
resents value  received,  while  unissued  or  unsubscribed 
stock  does  not  represent  value.  As  long  as  the  treas- 
ury stock  is  held  by  the  corporation  it  does  not  par- 
ticipate in  dividends  nor  can  it  be  voted  at  the  meetings 
of  the  corporation. 

Creating  treasury  stock  by  donation  from  the  in- 
corporators, to  whom  the  stock  was  originally  issued 
by  the  corporation  as  consideration  for  the  purchase 
of  assets,  or  for  services  performed,  is  often  made 
a  device  for  giving  away  stock  as  a  bonus  with 
bonds  or  for  selling  stock  below  par.  The  laws  of 
some  states  prohibit  the  issue  of  capital  stock  for 
less  than  par,  and  where  it  is  desired  to  do  this,  a 
board  of  directors  will  go  solemnly  thru  the  farce 
of  voting  to  issue  stock  for  property  or  for  services 
in  greater  amount  than  the  property  or  services  are 

173 


174     FINANCIAL  AND  BUSINESS  STATEMENTS 

worth  and  subsequently  acknowledge  the  donation  of 
stock  from  those  who  originally  received  it.  This 
stock  the  corporation  may  sell  for  any  price  and  in 
that  manner  accomplish  practically  the  issue  of  stock 
at  a  price  below  par. 

This  procedure  is  perfectly  legal,  owing  to  the  fact 
that  the  board  of  directors  has  sole  authority  to 
place  a  valuation  upon  assets  and  the  courts  will  up- 
hold whatever  valuation  they  do  place  upon  assets 
acquired  so  long  as  no  fraud  can  be  proved. 

As  an  illustration,  let  us  assume  that  the  owner 
of  a  patent  organized  a  corporation  for  the  purpose 
of  working  his  patent  and  received  in  return  for  the 
transfer  of  his  patent  rights,  $50,000  in  preferred 
stock  and  $50,000  in  common  stock.  Manifestly  he 
is  in  no  better  position  after  this  procedure  has  been 
affected  than  he  was  in  the  first  place  and  in  order 
that  the  necessary  funds  with  which  to  manufacture 
the  device  may  be  forthcoming,  he  donates  back  to 
the  company  part  of  his  stock  to  be  sold  for  what- 
ever price  it  will  bring  in  the  market.  If  the  device 
proves  to  be  successful  and  in  demand,  the  value  of 
the  remaining  shares  he  holds  will  be  considerably  en- 
hanced. Custom  seems  to  have  sanctioned  the  book- 
ing of  treasury  stock  at  par  but  if  it  is  known  at  the 
time  of  donation  what  price  it  will  bring,  the  stock 
may  be  taken  up  on  the  books  at  the  price  it  is  ex- 
pected to  realize.  The  complementary  credit  will  be 
either  a  capital  surplus  account,  or  stock  donation  ac- 
count, or  a  reserve  for  working  capital  account.     If 


TREASURY  STOCK  AND  ITS  TREATMENT      175 

any  of  the  stock  is  sold  at  less  than  the  price  for 
which  it  was  booked,  the  difference  between  the  price 
at  which  it  was  taken  up  on  the  books  and  the  sales 
price  realized  will  be  adjusted  thru  the  account  which 
was  credited  at  the  time  the  treasury  stock  was  orig- 
inally taken  up  in  the  accounts. 

After  all  the  treasury  stock  has  been  disposed  of, 
the  corporation  presumably  will  have  cash  or  other 
valuable  property  representing  the  proceeds  of  treas- 
ury stock  sold  and  the  reserve  account  or  the  capital 
surplus  account  will  still  remain  open  on  the  books 
for  the  adjusted  amount. 

2.  Disposition  of  donation  reserve  credit. — The 
next  question  to  be  decided  is  the  disposition  of  the 
credit  in  the  reserve  or  donation  account.  There  is 
no  legal  reason  why  this  amount  may  not  be  distribu- 
ted in  the  form  of  dividends.  Since  this  action  would 
defeat  the  purpose  of  the  donation  if  it  were  taken 
during  the  probation  period  of  the  life  of  the  cor- 
poration and  since  the  donor  in  all  probability  will 
retain  sufficient  control  of  the  corporation  to  prevent 
its  disposition  for  that  purpose,  it  is  probable  that 
the  surplus  will  not  be  disbursed  in  the  form  of  divi- 
dends. Some  authorities  suggest  that  the  credit  be 
used  to  write  down  the  inflated  assets.  However,  in-_ 
asmuch  as  this  would  be  an  admission  on  the  part  of 
the  board  of  directors  that  the  assets  were  over- 
valued in  the  first  place,  in  all  probability  the  board 
would  not  take  kindly  to  this  suggestion.  The 
amount  standing  at  the  credit  of  the  reserve  or  dona- 


176     FINANCIAL  AND  BUSINESS  STATEMENTS 

tion  account  will  therefore  remain  until  such  time 
as  the  company  is  in  a  fairly  prosperous  condition 
when  the  amount  will  find  its  way  to  surplus  and  ul- 
timately be  distributed. 

3.  Acquisition  of  treasury  stock  below  or  above 
par. — A  corporation  sometimes  acquires  its  capital 
stock  in  settlement  of  a  debt  due  to  it.  The  stock 
may  be  taken  over  at  par  value,  or  at  a  price  above 
par,  or  at  a  discount.  The  laws  of  some  states  pro- 
hibit a  corporation  from  acquiring  its  own  capital 
stock  while  in  other  states  this  is  permitted,  with  some 
restrictions.  Thus  in  New  York  State  a  corporation 
may  acquire  its  own  stock  provided  it  has  a  surplus 
and  provided  also  that  the  action  does  not  defraud 
the  creditors.  If  the  stock  is  acquired  at  a  price 
above  par  it  is  evident  that  the  premium  paid  for 
the  stock  constitutes  in  effect  a  distribution  of  so 
much  of  the  surplus  of  the  corporation  to  that  par- 
ticular stockholder.  Consequently  if  the  stock  is  not 
to  be  retired  and  cancelled,  it  is  probably  the  better 
practice  to  show  it  at  its  par  value  and  charge  the 
premium  paid  directly  against  the  surplus  account. 
If  the  stock  has  been  acquired  at  a  discount,  it  is 
evident  that  the  corporation  has  redeemed  a  part  of 
its  capital  stock  liability  for  less  than  par  and  in 
this  case  if  the  stock  is  not  to  be  cancelled  and  retired 
the  treasury  stock  should  be  shown  at  its  cost  price 
in  the  balance  sheet.  If  the  stock  is  to  be  retired,  the 
corporation  has  sustained  a  profit  equal  to  the  differ- 
ence between  the  par  value  and  the  price  paid  for 


TREASURY  STOCK  AND  ITS  TREATMENT      177 

the  stock.  This  may  be  credited  to  the  surplus  ac- 
count. Where  treasury  stock  that  has  once  been  is- 
sued has  come  back  into  the  treasury  and  is  cancelled, 
it  ceases  to  be  treasury  stock  and  reverts  to  the  status 
of  unissued  stock  thereby  reducing  the  outstanding 
capital  stock  liability.  ' 

4.  Stock  donated  to  cover  a  deficit. — The  stock- 
holders of  a  corporation  might  donate  back  part  of 
their  holdings  of  capital  stock  for  sale  so  as  to  enable 
the  corporation  to  wipe  out  a  deficit.  If  the  corpora- 
tion is  organized  under  the  laws  of  a  state  that  does 
not  permit  corporations  to  acquire  their  own  capital 
stock,  the  best  way  for  the  transaction  to  be  handled 
would  be  to  have  a  trustee  receive  the  stock  for  the 
benefit  of  the  corporation.  Then,  when  it  has  been 
sold  the  proceeds  will  be  turned  over  to  the  corpora- 
tion, which  would  debit  its  cash  account  and  credit  the 
deficit  account.  If  the  corporation  is  organized  un- 
der the  laws  of  a  state  that  permits  it  to  acquire  its 
own  capital  stock,  the  treasury  stock  would  be  debited 
and  capital  surplus  account  would  be  credited  until  the 
stock  was  sold.  When  the  stock  is  sold,  cash  would 
be  debited  and  treasury  stock  credited.  And  differ- 
ence between  the  price  at  which  the  treasury  stock  was 
taken  up  upon  the  books  and  the  price  at  which  it  was 
sold,  would  be  adjusted  thru  the  capital  surplus  ac- 
count. Thus  the  treasury  stock  would  always  appear 
on  the  books  for  the  same  value  as  the  amount  stand- 
ing at  the  credit  of  the  capital  surplus  account. 
When  the  entire  treasury  stock  has  been  disposed  of, 


178     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  credit  balance  in  the  capital  surplus  account  could 
be  transferred  to  the  credit  of  the  deficit  account,  thus 
wiping  out  the  deficit. 

REVIEW 

What  is  treasury  stock?     How  is  it  created  and  why? 
Describe    the    accounting    processes    when    treasury    stock    is 
created  thru  donation  of  the  incorporators. 


CHAPTER  XIII 

INTERPRETATION  OF  LIABILITIES 

1.  Liabilities  defined  and  classified. — A  liability  is 
a  claim  against  a  debtor  which  gives  to  the  creditor 
a  right  of  action  at  law.  Liabilities  are  to  be  dis- 
tinguished from  accountabilities.  Thus,  a  factor  who 
receives  a  consignment  of  goods  from  a  shipper  is 
accountable  to  the  shipper  for  the  goods  or  the  pro- 
ceeds of  sales.  No  liability,  however,  attaches  to  the 
consignee  beyond  that  of  taking  ordinary  care  of  the 
property  of  the  shipper,  until  such  time  as  he  has  sold 
a  portion  of  the  goods  and  collected  the  proceeds. 
Then  the  relation  of  liability  arises. 

Under  American  practice  the  right  hand  side  of  the 
balance  sheet,  as  we  have  seen,  contains  two  classes 
of  rights,  those  of  the  creditors,  and  those  of  the  pro- 
prietor. 

The  reader  has  seen  in  the  Text  on  "Accounting 
Practice,"  that  capital  is  not  to  be  considered  as  a 
strict  liability.  Liabilities  are  broadly  classified  in 
two  groups, — fixed  and  current.  The  former  are 
those  liabilities  which  have  more  than  one  year  to  run 
from  the  date  of  the  balance  sheet ;  the  latter  comprise 
those  liabilities  which  must  be  liquidated  out  of  the 
current  assets  and  are  payable  at  the  latest  within 

179 


180     FINANCIAL  AND  BUSINESS  STATEMENTS 

one  year.  Liabilities  are  also  divided  into  funded 
debt  and  unfunded  debt.  Funded  debt  consists  of 
debt  for  which  definite  provision  for  repayment  has 
been  made.  A  funded  debt  is  usually  secured  by  a 
mortage  or  other  hen.  Unfunded  debt  is  that  debt 
which  rests  upon  the  general  credit  of  the  business 
and  for  which  no  definite  provision  for  repayment 
has  been  made. 

This  classification  as  between  funded  debt  and  un- 
funded debt  is  not  adopted  by  all.  For  example, 
there  are  some  who  class  debenture  bonds  as  funded 
debt,  even  tho  no  provision  may  have  been  made  for 
the  ultimate  repayment  of  the  debentures. 

Fixed  liabilities  are  also  called  capital  liabilities  be- 
cause they  represent  the  part  of  the  capital  income  of 
an  undertaking  which  has  been  invested  in  assets  of  a 
permanent  character  or  capital  assets.  The  reader 
has  already  seen  from  the  Text  on  "Corporation 
Finance"  the  difficulty  in  many  instances  of  deter- 
mining from  the  mere  names  the  character  of  the  vari- 
ous classes  of  financial  instruments  or  evidences  of 
debts  which  are  found  in  practice.  In  the  present 
volume,  we  are  not  concerned  with  the  nature  of  these 
evidences  of  debts  or  with  the  security  underlying 
them.  From  the  accounting  standpoint,  we  are  in- 
terested in  seeing  that  the  character  of  the  debt  is 
stated  clearly  in  the  accounts. 

2.  Bonded  debt. — A  bonded  debt  of  a  firm  con- 
sists of  that  debt  which  is  evidenced  by  an  issue  of 
bonds.     It  may  be  secured  or  unsecured  and  provision 


INTERPRETATION  OF  LIABILITIES         181 

for  its  repayment  may  or  may  not  be  made.  In  order 
to  determine  the  nature  and  kind  of  bonds  shown  in  a 
financial  statement,  it  may  be  necessary  in  some  in- 
stances to  obtain  at  cost  an  abstract  of  the  instrument 
and  indenture  underlying  these  bonds,  assuming, 
rightfully,  that  such  an  instrument  exists.  Bonded 
debts  may  be  secured  by  a  pledge  of  real  property  or 
by  a  pledge  of  personal  property.  The  distinguish- 
ing features  of  each  class  will  be  the  security,  if  any, 
underlying  the  debt;  the  rate  of  interest;  the  date 
of  maturity;  and  the  interest  dates.  All  obligations 
of  a  business  which  agree  in  all  respects  with  the  four 
classifications  mentioned  above  should  be  shown  in 
the  same  account. 

Where  a  debt  is  secured  by  a  mortgage  or  a  pledge 
of  personal  property,  the  property  covered  by  the 
mortgage  should  be  plainly  indicated  in  the  title  of  the 
account,  thus,  "first  mortgage  5  per  cent  bonds,"  or 
"collateral  trust  5  per  cent  bonds."  Where  a  mort- 
gage has  been  issued  underlying  the  bonds,  it  is  evi- 
dent that  there  has  been  a  definite  pledge  of  a  fixed 
amount  of  the  company's  property  and  the  real  lia- 
bility is  the  amount  of  the  mortgage  and  not  the 
amount  of  the  bonds  which  may  be  issued  and  out- 
standing. When  the  bonds  are  secured  by  a  mort- 
gage, unissued  bonds  differ  from  unissued  stock. 
The  unissued  bonds  have  a  value,  because  underlying 
them  there  is  a  pledge  of  property  and  it  would  be 
preferable  to  treat  unissued  bonds  in  a  balance  sheet 
as  an  asset,  because  they  represent  a  security  which 


182     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  officers  of  the  organization  may  dispose  of  at  any 
time.  They  may  also  be  used  at  any  time  as  security 
for  advances  or  for  other  obligations  or  debts.  The 
entire  authorized  issue  of  bonds  would  appear  as  a  lia- 
bility for  the  full  amount  of  the  mortgage  shown. 
Unissued  stock,  however,  has  no  value,  nor  does  value 
attach  to  it  until  it  has  been  exchanged  for  cash  or  its 
equivalent.  Therefore,  it  is  important  that  the 
amount  of  all  mortgages  and  pledges  of  property  to 
secure  evidences  of  debt  be  set  forth  clearly  in  the 
balance  sheet. 

Where  the  amount  of  bonds  issued  and  outstand- 
ing is  less  than  the  amount  of  the  mortgage  under- 
lying the  issue,  it  is  important  to  note  the  amount  of 
the  property  pledged,  so  that  any  one  who  reads  the 
balance  sheet  of  the  organization  may  be  able  to  de- 
termine what  assets  remain  unpledged. 

Overissue  of  bonds  is  usually  guarded  against  by 
clauses  in  the  indenture  providing  for  registration  and 
certification.  The  fact  that  these  requirements  have 
not  been  followed  does  not  alter  the  status  of  un- 
issued bonds.  Where  part  of  the  unissued  bonds  have 
been  registered  and  part  have  not,  the  facts  will  usu- 
ally be  stated  in  the  balance  sheet.  The  necessity  of 
showing  the  amount  of  the  mortgage  underlying  the 
bonds  compels  this  treatment  to  be  applied  to  unis- 
sued bonds. 

Where,  therefore,  more  than  one  mortgage  or  lien 
exists  on  the  whole  or  any  part  of  the  property  of  an 
enterprise,  it  is  important  to  have  the  mortgages  and 


INTERPRETATION  OF  LIABILITIES         183 

liens  listed  separately  in  the  balance  sheet,  and  to  de- 
scribe the  property  upon  which  liens  attach. 

It  will  occasionally  happen  that  the  unissued  evi- 
dences of  debt  secured  by  a  mortgage  of  a  corpora- 
tion may  be  given  as  collateral  security  for  loans  ob- 
tained from  banks.  When  this  is  the  case,  the  loan 
from  the  bank  should  be  stated  as  a  current  liability,  if 
it  has  less  than  a  year  to  run.  A  notation  showing  the 
amount  of  bonds  which  have  been  pledged  as  col- 
lateral security  for  the  loan  should  be  appended. 

The  difference  between  the  value  of  the  property 
which  is  pledged  and  the  amount  of  debt  evidences 
issued  against  it,  constitutes  the  equity  of  the  pro- 
prietor. 

In  those  cases  in  which  it  is  not  possible  to  show 
conveniently  the  nature  of  the  debt  and  the  property 
pledged  as  security  in  a  balance  sheet,  a  separate 
schedule  should  be  attached  to  the  balance  sheet  dis- 
closing this  information. 

3.  Mortgage  debts  and  bonds. — A  concern  may 
mortgage  its  property,  in  which  case  the  mortgage  is 
usually  given  to  one  individual  on  a  single  bond  se- 
cured by  the  mortgage.  While  the  legal  debt  is  the 
bond  and  the  mortgage  is  merely  security  for  it,  yet 
in  the  last  analysis  the  real  debt  is  the  mortgage. 

Ileal  estate  mortgages  are  conveyances  of  title  on 
the  condition  that  the  title  of  the  mortgagee  shall  be 
defeated  when  the  debt  is  paid.  They  are  executed, 
acknowledged  and  recorded  like  a  deed.  Chattel 
mortgages  which  cover  personal  property  do  not  usu- 


184     FINANCIAL  AND  BUSINESS  STATEMENTS 

ally  convey  title.  They  are  usually  for  shorter  terms 
than  real  estate  mortgages  and  for  that  reason  are 
usually  classified  under  the  heading  of  current  liabili- 
ties. In  the  majority  of  cases,  chattel  mortgages  are 
given  as  additional  security  for  merchandise  pur- 
chased on  credit  or  for  movable  property  purchased 
on  credit.  Thus,  for  example,  a  man  may  sell  mer- 
chandise to  a  firm  on  open  account,  taking  in  exchange 
a  chattel  mortgage  on  the  stock  as  additional  secur- 
ity. If  such  mortgages  are  not  disclosed  in  the  finan- 
cial statement,  one  who  is  about  to  grant  credit  on 
such  a  balance  sheet  would  be  greatly  misled,  be- 
cause the  balance  sheet  would  appear  to  show  more 
unpledged  assets  than  the  borrower  had. 

Interest  on  bonded  debt  or  on  mortgage  debt  should 
be  accrued  because  interest  accrues  from  day  to  day 
and  at  the  time  of  stating  the  accounts,  the  interest 
accrued  should  be  shown  in  the  balance  sheet  as  a  cur- 
rent liability. 

4.  Notes  payable. — Classified  under  this  head 
would  be  the  promissory  notes  gives  by  a  firm  to  its 
creditors  or  issued  as  an  accommodation  to  others. 
These  are  usually  payable  in  less  than  a  year,  and 
therefore  would  be  classified  under  the  current  liabili- 
ties. If  the  notes  bear  interest,  the  interest  should  be 
accrued  up  to  the  date  of  the  balance  sheet.  If  the 
firm  has  accepted  a  draft  or  a  bill  of  exchange,  it  may 
be  handled  in  the  same  account,  as  the  draft  is  the 
same  as  a  promissory  note  for  all  practical  purposes. 
Where  it  is  desired  to  keep  the  two  classes  of  instru- 


INTERPRETATION  OF  LIABILITIES        185 

ments  separate,  this  may  be  done  by  creating  one 
account  for  notes  payable  and  another  account  for 
drafts  payable. 

5.  Trade  creditors. — Included  under  this  caption 
would  be  the  amount  due  for  merchandise  or  property 
purchased,  as  well  as  the  amount  due  for  expenses  of 
various  kinds  incurred  in  the  ordinary  course  of  busi- 
ness. 

6.  Salaries  and  wages  accrued. — This  account 
would  include  the  amount  due  and  unpaid  for  claims 
of  officers  and  employes  or  amounts  due  partners  in 
respect  of  salaries  and  wages.  The  amount  set  up 
as  a  liability  should  be  the  amount  accrued  from  the 
last  date  of  payment. 

7.  Other  liabilities. — Taxes  accrued  up  to  the  date 
of  a  balance  sheet  should  be  shown  as  a  current  liabil- 
ity. The  account  "taxes  accrued,"  would  also  include 
the  estimated  portion  of  the  Federal  Income  Tax  ac- 
crued up  to  the  date  of  the  balance  sheet.  Rents  ac- 
crued, royalties  accrued  and  dividends  declared  and 
payable  are  examples  of  other  liabilities  that  may  be 
found  in  a  balance  sheet. 

With  reference  to  dividends,  it  is  to  be  noted  that 
until  the  board  of  directors  has  met  and  actually  de- 
clared and  published  the  declaration  of  a  dividend, 
that  dividend  is  not  a  liability.  It  follows  from  this 
that  unpaid  dividends  on  cumulative  preferred  stock, 
not  declared  by  the  board  of  directors,  are  not  a  lia- 
kUitv  of  the  corporation.  Nevertheless,  they  should 
«5e  stated  in  a  footnote  in  the  balance  sheet,  because 


186     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  failure  to  do  so  would  mislead  possible  investors  in 
the  common  stock  of  the  undertaking. 

8.  Ratio  of  current  assets  to  current  liabilities. — 
The  reader  of  the  balance  sheet  of  an  undertaking 
will  compare  the  ratio  existing  between  current  lia- 
bilities and  current  assets.     For  example,  the  balance 
of  the  cash  account  would  be  considered  in  connection 
with  the  amount  of  wages  and  current  liabilities  due. 
With  reference  to  loans  payable,  one  would  look  for 
fluctuations.     Thus,  during  the  season  in  which  an 
undertaking  is  acquiring  its  merchandise  and  getting 
it  ready  for  market,  there  will  be  a  constant  increase 
in  the  amount  of  the  outstanding  accounts  and  notes 
payable.     At  the  end  of  the  season,  or  at  the  end  of 
the  normal  fiscal  year,  one  would  expect  to  see  the 
accounts  payable  reduced  to  an  amount  representing 
perhaps  current  bills  not  yet  due.     One  would  also 
expect  to  find  that  all  the  bank  loans  had  been  paid 
off.     If  loans  for  a  relatively  large  sum  were  out- 
standing at  the  end  of  the  normal  fiscal  period  or  at 
the  end  of  the  season,  it  would  be  an  indication  that 
the  concern  was  financing  itself  permanently  on  bor- 
rowed capital.     This  proceeding  might  be  a  danger- 
ous one,  because  the  loan  might  be  called  at  any  time 
and  the  firm  might  be  unable  to  repay  it  on  demand. 
A  business  should  have  a  sufficient  amount  of  owned 
capital  to  take  care  of  its  ordinary  financial  needs  at 
the  end  of  the  fiscal  or  season  period. 

9.  Deferred  liabilities  or  deferred  credits  to  in- 
come,— Deferred  credits  to  income  consist  of  those 


INTERPRETATION  OF  LIABILITIES         187 

items  received  in  the  current  period  which  have  not  as 
yet  been  earned.  These  items  should  not  properly  be 
credited  to  income  in  the  present  period  and  the  credit 
to  income  is  deferred  until  later.  From  the  point  of 
view  of  proprietorship,  they  are  liabilities  in  that  they 
represent  the  liability  of  the  organization  to  deliver 
service  in  a  later  period.  Thus,  for  example,  a  tenant 
may  pay  rent  in  advance  and  at  the  date  of  the  bal- 
ance sheet  a  certain  portion  of  the  rent  paid  in  ad- 
vance will  have  been  earned  and  a  portion  will  be  un- 
earned. The  portion  unearned  is  set  up  as  a  de- 
ferred credit  to  income  because  it  represents  the  rent 
service  which  the  tenant  is  to  enjoy  from  the  landlord 
during  the  following  period.  Deferred  liabilities  are 
the  reverse  of  deferred  assets. 

10.  Contingent  liabilities. — Contingent  liabilities, 
as  the  reader  will  recall,  are  those  which  may  or  may 
not  occur  upon  the  happening  of  a  certain  event  or 
contingency  arising  out  of  past  transactions.  The 
most  common  examples  of  contingent  liability  are 
those  of  liability  under  notes  receivable  which  have 
been  discounted  and  liability  as  guarantor  of  the 
principal  or  interest  on  the  debt  of  another  firm. 
The  important  features  of  the  contingent  liability  on 
notes  receivable  discounted,  have  been  considered. 
Liability  as  guarantor  for  the  principal  and  interest 
of  the  debt  of  another  is  such  a  liability  as  a  holding 
company  might  assume  as  guarantor  of  the  principal 
and  interest  of  the  debt  of  a  subsidiary.  Contingent 
liabilities  will  be  offset  by  contingent  assets.     Thus, 

XXII— 14 


188     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  contingent  asset  offsetting  the  contingent  liability 
for  a  note  receivable  discounted  is  the  claim  which 
arises  against  the  maker  of  the  note  if  the  liability  be- 
comes actual.  Of  course,  the  value  of  the  contingent 
asset  depends  upon  the  ability  of  the  maker  to  pay. 
Where  one  has  assumed  contingent  liability  as  guar- 
antor of  the  principal  and  interest  of  the  debt  of  an- 
other, the  guarantor  usually  protects  himself  by  tak- 
ing security.  If  the  security  taken  by  the  guarantor 
is  equivalent  to  the  amount  of  his  liability,  the  con- 
tingent asset  is  equivalent  to  the  contingent  liability; 
otherwise,  of  course,  a  loss  results. 

It  is  not  customary  to  show  contingent  assets  and 
contingent  liabilities  in  the  balance  sheet  proper. 
Nevertheless,  contingent  liabilities  should  be  stated 
in  a  footnote  in  the  balance  sheet,  if  not  included  in 
the  balance  sheet  itself.  If  both  contingent  assets 
and  contingent  liabilities  are  included  in  the  balance 
sheet,  they  will  be  grouped  under  their  appropriate 
caption. 

11.  Conclusions  to  be  inferred  from  the  liabilities. 
— Having  thus  considered  the  nature,  interpretation 
and  the  valuation  of  assets  and  liabilities,  it  remains 
now  to  consider  what  inferences  may  be  drawn.  The 
capital  assets  or  the  fixed  assets  are  usually  acquired 
in  part  by  the  issue  of  fixed  liabilities  and  capital  stock. 
In  all  cases  there  should  be  a  reasonable  equity  in  the 
fixed  property.  In  other  words,  bondholders  and 
mortgagees  ought  to  be  protected  by  a  reasonable 


INTERPRETATION  OF  LIABILITIES         189 

equity  against  the  possibility  of  loss.  What  this 
equity  should  be  depends  upon  circumstances,  but  in 
practice  it  should  seldom  be  less  than  25  per  cent. 

Creditors  on  open  accounts  as  well  as  bondholders 
are  also  interested  in  the  relation  which  exists  between 
current  assets  and  current  liabilities.  There  should 
always  be  a  reasonable  excess  of  quick  assets  over 
quick  liabilities  in  every  concern  that  issues  mortgaged 
or  bonded  debts.  Here,  again,  ratios  vary  because  the 
conditions  will  vary  in  the  different  lines  of  business. 
In  the  meat  packing  industry,  the  quick  assets  will 
show  a  much  better  ratio  than  in  the  textile  industry, 
because  of  certain  differences  in  the  nature  of  the 
business  transactions.  At  any  rate,  under  ordinary 
circumstances,  there  should  be  at  least  twice  the 
amount  of  quick  assets  as  of  quick  liabilities.  A 
large  amount  of  cash  on  hand  and  a  large  amount  of 
accounts  payable  might  be  an  indication  of  careless 
management.  If  the  accounts  payable  are  subject  to 
cash  discounts,  it  might  be  more  profitable  for  the 
organization  to  increase  its  loans  and  use  the  cash  in 
the  reduction  of  accounts  payable  thru  taking  ad- 
vantage of  all  discounts.  A  business  cannot  stand 
still  for  any  length  of  time.  It  will  either  advance 
or  go  backward. 

Unfavorable  conditions  that  do  not  show  improve- 
ment will  be  due  to  the  following  possible  causes.  It 
may  be  that  the  machinery  and  processes  which  are  in 
use  are  not  the  best  to  be  had  or  the  most  modern  that 


190     FINANCIAL  AND  BUSINESS  STATEMENTS 

science  has  developed.  Perhaps  new  blood  is  neces- 
sary in  the  sales  organization  or  in  the  operating  de- 
partment. Suggestions  may  sometimes  be  obtained 
from  a  study  of  the  methods  of  competitors. 

A  careful  study  of  all  those  factors  and  an  impartial 
analysis  of  financial  statements  by  all  those  inter- 
ested in  any  business,  will  benefit  not  only  the  business 
men  themselves,  but  also  the  vast  army  of  employes 
who  are  dependent  upon  the  prosperity  of  those  who 
foot  the  pay-roll. 

The  following  is  an  illustration  of  an  Income  and 
Profit-and-Loss  Statement  and  a  Balance  Sheet  of  a 
manufacturing  establishment. 

THE  ACME  METAL  PRODUCTS  COMPANY 

General  Balance  sheet — December  31,  1911. 

ASSETS 
Capital  Assets: 

Land     $100,000.00 

Buildings     150,000.00 

Machinery  and  equipment 74,360.00 

Stocks  and  bonds  of  controlled  companies.  200,000.00 

Furniture  and  fixtures 20,000.00 

Good-will    150,000.00 

Total  capital  assets   $    694,360.00 

Working  and  trading  assets: 

Materials  and  supplies  inventory   $  66,838.20 

Finished  goods  inventory  172,727.50 

Total  working  and  trading  assets...  $   239,565.70 

Current  assets: 

Cash  on  hand  and  in  bank $  43,960.00 

Accounts  receivable   109,870.00 

Notes  receivable   18,000.00 

Total  current  assets $    171,830.00 

Sinking  fund   15,000.00 


INTERPRETATION  OF  LIABILITIES        191 

Deferred  charges  to  expense: 

Prepaid  insurance    $     7,500.00 

Advertising  paid  in  advance  2,175.00 

Rent  paid  in  advance 100.00 

Organization  expense 12,000.00 

Total  deferred  charges  "~~  $     21,775.00 

Total  assets    $1,142,530.70 

LIABILITIES  AND  CAPITAL 

Capital  Liabilities: 

First  mortgage  bonds  authorized $400,000.00 

Less— unissued    200,000.00 

Issued  and  outstanding $   200,000.00 

Current  Liabilities: 

Accounts  pavable   $    5,896.00 

Notes  payable    10,000.00 

Dividends  payable    40,000.00 

Interest  accrued  and  due  10,000.00 

Interest  accrued  not  due   t.  .  2,000.00 

Royalties  accrued  7,960.00 

Taxes  accrued    3,500.00 

Wages  accrued    t 1,500.00 

Total  current  liabilities  $     80,856.00 

Reserves : 

For  depreciation — machinery  and  equipment  $  22,690.00 

—buildings     48,000.00 

"             "            —good-will  16,290.00 

Sinking  fund  reserve 15,000.00 

Insurance  reserve   8,000.00 

For  doubtful  accounts 12,570.00 

Total  reserves    $     122,550.00 

Capital  Stock: 
Preferred: 

Authorized  issue — 6,000  shares — par  value 

$100  each    $600,000.00 

Less  unissued 100,000.00 

Issued  and  outstanding $500,000.00 

Common : 
Authorized,  issued  and  outstanding — 2,000 

shares,  par  value  $100  each 200,000.00 

Surplus— December  31,  1911   $    700,000.00 

Total  liabilities  and  capital   . . .  39,124.70 

$1,142,530.70 


FINANCIAL  AND  BUSINESS  STATEMENTS 

Statement  of  Income  and  Profit  and  Loss  for  the  year  ended 

December  31st,  1911. 

Gross  sales   $720,290.00 

Less— returns     14,063.00 

Net   sales    $706,227.00 

Deductions  from  sales: 
Trade  discounts    $60,296.00 

Allowances : 

Defective    goods    $  7,892.00 

Breakage     8,920.00 

Rebates    44,825.00 

Outward  fgt.  and  ctge 7,890.00     69,527.00 

Total  deductions  from  sales $129,913.00 

Amount  realized  on  sales  $576,314.00 

Cost  of  goods  sold:     Schedule  No.  1 420,300.00 

Gross  profit  on  sales  $156,014.00 

Selling  expense: 

Salaries — sales  manager  and  clerks   $  8,000.00 

Salesmen: 

Salaries    11,500.00 

Traveling   expenses 3,300.00 

Commissions     4,000.00 

Advertising     4,580.00 

Entertaining   customers    1,200.00 

Total  selling  expenses   $  32,580.00 

Selling  profit   $123,434.00 

Administrative  expenses: 

Salaries  of  officers   $25,000.00 

Salaries  of  general  office  clerks  12,000.00 

Directors'  fees   1,000.00 

Printing  and  stationery    4,500.00 

Postage    3,060.00 

Telephone  and  telegraph   2,700.00 

Traveling — officers  and  clerks   1,500.00 

Legal  expenses    4,006.00 

Total  administrative  expenses    $  53,766.00 

Net  profit  on  sales — income  from  operations $  69,668.00 


INTERPRETATION  OF  LIABILITIES         193 

Other  income: 

Interest  on  bonds  owned  $  5,000.00 

Dividends  on  stocks  owned  6,000.00 

Cash  discount  on  purchases  300.00 

Interest  on  bank  balances   265.00 

Interest  on  notes  receivable   480.00 

Rent   ■ 1,000.00 

Total  other  income  $  13,045.00 

Total  income    $  82,713.00 

Deductions  from  income: 

Interest  on  bonds   $10,000.00 

Interest  on  notes  payable   3,000.00 

Cash  discount  on  sales   1,750.00 

Rent   300.00 

Insurance  expense    12,000.00 

Taxes  " 15,750.00 

Royalties     16,525.00 

Total  deductions  from  income  $  59,325.00 

Net  income  profit  and  loss  $  23,388.00 

Profit  and  loss  credits: 

Profit  on  sale  of  securities   $20,000.00 

Bad  debts  previously  written  off— now  collected     14,000.00 

Total  profit  and  loss  credits  $  34,000.00 

Total    $  57,388.00 

Profit  and  loss  charges: 

Provision  for  doubtful  accounts   $  5,000.00 

Provision  for  depreciation  of  bldgs ,. 10,000.00 

Provision  for  depreciation  of  good-will   3,000.00 

Organization  expense — written  off   2,000.00 

Total  profit  and  loss  charges   $  20,000.00 

Profit  and  loss — surplus  for  year  $  37,388.00 

Profit  and  loss — surplus  at  beginning  of  year. . .  49,736.70 

Gross  surplus  at  December  31,  1911  $  87,124.70 

Appropriations  of  surplus: 

Insurance  reserve   $  3,000.00 

Sinking  fund  reserve    5,000.00 

Dividends   declared    40,000.00 

Total  appropriations   $  48,000.00 

Corporate  surplus  at  December  31,  1911 $  39,124.70 


194     FINANCIAL  AND  BUSINESS  STATEMENTS 


THE  ACME  METAL  PRODUCTS  CO. 

Schedule  showing  Cost  of  Goods  Sold  during  Year  ended 
December  31,  1911. 

Cost  of  goods  sold: 
Manufactured  cost: 
Prime  cost: 

Material  and  supplies  consumed  $365,506.92 

Labor— direct     90,769.03 

Total  prime  cost $356,375.95 

Manufacturing  overhead : 

Labor— indirect   ,.     $  29,307.04 

Power     9,294.36 

Factory  supplies  3,987.35 

Depreciation — machinery  equipment  3,713.39 

Salaries — factory  manager  and  clerks   23,038.90 

Factory  office  expense   1,200.38 

Factory  general  expense  3,344.97 

Total  manufacturing  overhead   $  70,786.09 

Total  manufacturing  cost   $427,062.04 

Finished  goods — deduct  increase  in  inventory  6,762.04 

Total  cost  of  goods  sold $420,300.00 

REVIEW 

State  the  distinction  between  a  liability  and  an  accountability, 
and  discuss  the  various  kinds  of  liabilities. 

Explain  the  nature  of  funded  debt  as  distinguished  from  cur- 
rent liability. 

What  accruals  are  to  be  considered  as  liabilities? 

What  are  contingent  liabilities  and  contingent  assets,  and  how 
far  should  they  be  recognized  in  the  balance  sheet? 

What  information  can  be  looked  for  in  a  scrutiny  of  the 
liabilities  ? 


CHAPTER  XIV 

SURPLUS,  RESERVES  AND  DIVIDENDS 

1.  Definition  of  surplus. — By  the  term  surplus,  is 
meant  the  intrinsic  value  of  all  the  assets  of  a  firm, 
over  and  above  its  liabilities  and  outstanding  capital. 
Intrinsic  value  is  to  be  distinguished  from  reproduc- 
tive value  in  that  the  former  relates  to  the  actual  cost 
of  the  assets  acquired,  less  the  depreciation  sustained 
since  acquisition,  and  the  latter,  to  the  cost  of  duplica- 
tion on  the  basis  of  ruling  market  prices. 

The  author  is  a  firm  believer  in  the  rigid  cost  theory 
of  value  in  so  far  as  the  books  of  account  are  con- 
cerned. It  should  be  borne  in  mind  that  purchase 
price  may  not  represent  the  true  value.  This  is  due 
to  the  fact  that  assets  can  be  purchased  at  a  cost 
greater  or  less  than  the  true  value.  Some  authori- 
ties justify  the  use  of  true  value  based  upon  a  prop- 
erly made  appraisal  as  the  basis  for  placing  assets  on 
the  books. 

2.  Kinds  of  surplus. — Open  surplus  is  that  which 
appears  on  the  books  in  the  form  of  surplus,  reserves 
or  undivided  profits. 

Hidden  surplus  is  represented  in  the  form  of  secret 
reserves  as  a  result  of  accumulation  of  profits  that  do 
not  appear  on  the  books. 

195 


196     FINANCIAL  AND  BUSINESS  STATEMENTS 

Surplus  may  also  be  distinguished  as  free  and  re- 
stricted. By  the  former  is  meant  that  form  of  sur- 
plus that  represents  profit  available  for  distribution; 
by  the  latter,  a  profit  accumulation  which  for  one 
reason  or  another  is  to  be  retained  in  the  business. 

3.  Relative  importance  of  surplus  and  assets. — The 
importance  of  the  surplus  account  is  due  to  the  fact 
that  the  stockholder  finds  reflected  there  the  net  re- 
sults of  the  company's  operations;  he  measures  the 
value  of  the  company's  stock  by  the  fluctuations  in  the 
surplus  account.  The  importance  of  using  the  proper 
basis  for  the  valuation  of  the  firm's  assets  thus  be- 
comes apparent,  for  an  incorrect  valuation  is  at  once 
reflected  in  the  surplus  account. 

4.  Sources  of  surplus. — Broadly  speaking,  surplus 
may  be  derived  from  the  following  sources : 

(1)  from  profits  as  a  result  of  business  operations; 

(2)  from  a  revaluation  of  fixed  assets; 

(3)  from  an  original  investment  at  the  time  of 
organization  or  as  a  result  of  reorganization. 

5.  Surplus  resulting  from  business  operations. — 
The  reader  is  already  familiar  with  corporate  surplus 
resulting  from  business  operations.  He  will  also  re- 
call that  inasmuch  as  a  business  may  have  primary  and 
secondary  operations,  surplus  will  necessarily  be  either 
from  primary  or  secondary  operations,  or  from  both. 

6.  Importance  of  distinguishing  between  capital 
and  revenue  expenditure. — It  is  self-evident  that 
there  will  be  an  overstatement  of  the  surplus  if  all  the 


SURPLUS,  RESERVES  AND  DIVIDENDS      197 

elements  of  cost  have  not  been  included  in  the  profit 
and  loss  account.  One  of  the  problems  in  that  con- 
nection is  the  proper  allocation  of  expenditures  to 
capital  and  revenue.  If  an  expenditure  that  should 
have  been  charged  to  revenue  is  charged  to  a  capital 
account,  the  assets  will  be  increased  and  the  expenses 
will  be  decreased  by  the  same  amount.  Conversely,  if 
an  item  that  should  have  been  charged  to  capital  is 
charged  to  revenue,  the  assets  will  be  undervalued  and 
the  expenses  will  be  correspondingly  overstated. 

In  the  first  instance,  the  surplus  will  be  erroneously 
increased,  and  in  the  second  case  it  will  be  less  than 
it  should  be.  The  general  principle  to  bear  in  mind 
is  that  it  is  allowable  to  charge  to  revenue  any  ex- 
penditure that  does  not  enlarge  the  field  of  opera- 
tions or  that  results  in  an  increase  in  earning  power, 
or  in  a  decrease  in  the  expense  of  conducting  the  busi- 
ness. Inasmuch  as  the  application  of  these  principles 
oftentimes  is  attended  with  difficulty,  it  is  important 
in  reading  financial  statements  to  consider  what  has 
been  the  practice  of  the  company  in  connection  with 
expenditures,  as  reflected  by  the  surplus. 

7.  Depreciation  as  an  element  of  cost. — In  consid- 
ering the  surplus,  the  fact  that  depreciation  is  an  im- 
portant element  in  the  income  account  must  not  be 
overlooked.  If  the  depreciation  of  both  fixed  and 
circulating  assets  has  not  been  provided  for  by 
charges  against  earnings,  the  surplus  account  will  be 
overstated.  Depreciation  on  fixed  assets  may  be 
broadly  viewed  as  a  sort  of  rental  that  the  operating 


198     FINANCIAL  AND  BUSINESS  STATEMENTS 

department  of  a  business  pays  for  the  use  of  the  assets. 
Depreciation  on  all  circulating  assets,  such  as  ac- 
counts receivable  and  inventory,  should  also  be  pro- 
vided for,  before  net  profits  are  shown. 

8.  Reserves  that  are  not  part  of  surplus. — It  is 
maintained  by  some  accountants  that  all  reserves  are 
a  part  of  surplus,  but  such  a  contention  is  not  true 
of  any  reserve  created  to  measure  depreciation  or  to 
offset  an  anticipated  loss  on  the  realization  of  ac- 
counts receivable.  This  holds  good  notwithstanding 
the  fact  that  reserves  of  this  character  are  frequently 
found  on  the  liability  side  of  a  balance  sheet  included 
with  other  reserves.  The  use  of  reserves  for  the  pur- 
pose of  adjusting  the  valuation  of  assets  in  the  bal- 
ance sheet  is  purely  a  question  of  bookkeeping  expedi- 
ency. If  a  loss  equivalent  to  that  shown  in  the  re- 
serve accounts  has  been  sustained,  or  is  anticipated, 
the  shrinkage  may  be  credited  directly  to  the  asset 
account;  at  the  same  time  the  profits  of  the  period 
may  be  reduced  by  the  same  amount,  or  the  decline 
in  value  may  be  credited  to  a  reserve  account.  When 
decreases  in  value  are  credited  to  a  reserve  account  the 
record  will  be  clearer  if  the  reserve,  being  an  adjunct, 
is  offset  against  the  asset  affected  when  the  balance 
sheet  is  prepared. 

9.  Inter-company  profits  on  inventory  should  be 
eliminated  from  surplus. — The  reader  will  recall  the 
discussion  with  regard  to  profits  of  holding  companies 
as  given  in  Chapter  VI.  Subsidiary  companies  fre- 
quently do  business  with  one  another  and  the  transac- 


SURPLUS,  RESERVES  AND  DIVIDENDS      199 

tions  between  companies  will  usually  be  invoiced  at 
or  near  the  prevailing  market  prices.  Let  us  assume 
that  Company  A,  a  mining  company,  sells  the  greater 
portion  of  its  output  to  Company  B,  which  operates 
a  steel  mill  that  turns  out,  in  the  form  of  bars  or 
blooms,  material  received  from  Company  A.  Let 
us  further  assume  that  the  product  made  by  Company 
B  is  shipped  over  Railroad  C,  owned  by  the  holding 
company  to  another  subsidiary,  Company  D,  which 
operates  a  rod  mill.  Both  Company  B  and  Company 
D  sell  to  outsiders  as  well  as  to  Company  E,  which 
we  shall  assume  is  another  subsidiary  company,  en- 
gaged in  the  manufacture  of  certain  specialties.  The 
entire  output  of  Company  E  is  disposed  of  to 
outsiders. 

The  subsidiaries  will  have  on  hand,  included  in  their 
material  inventories,  at  the  close  of  the  fiscal  period, 
goods  which  have  been  purchased  from  other  sub- 
sidiaries and  upon  which  the  latter  have  made  a  profit. 
The  raw  material  of  Company  D  is  the  finished  prod- 
uct of  Company  B ;  the  finished  products  of  Company 
B  and  Company  D  constitute  the  raw  material  of 
Company  E. 

In  the  preparation  of  a  balance  sheet  of  the  holding 
company,  a  consolidation  of  the  assets  and  liabilities 
of  the  subsidiaries  will  make  it  possible  to  take  up,  as 
inventory  of  materials,  certain  quantities  purchased 
from  other  subsidiaries,  upon  which  the  latter  have 
already  made  a  profit  which  is  represented  in  the  sur- 
plus accounts  of  the  subsidiaries.     Each  of  the  sub- 


200     FINANCIAL  AND  BUSINESS  STATEMENTS 

sidiaries  has  a  separate  corporate  existence  and,  as 
far  as  its  own  accounts  are  concerned,  has  made  a 
valid  profit.  It  is  important  to  remember,  however, 
that  from  the  standpoint  of  the  entire  aggregation  no 
profit  has  as  yet  been  realized  on  that  material  which 
was  sold  by  one  subsidiary  and  remains  on  hand  in 
the  inventory  of  another  subsidiary. 

That  this  is  an  important  factor  affecting  surplus 
may  be  seen  from  an  analysis  of  the  balance  sheet  of 
the  United  States  Steel  Corporation  for  the  year  end- 
ing December  31,  1915.  The  inventory  of  raw  ma- 
terial on  hand  in  the  subsidiary  companies  at  that  date, 
amounted  to  $161,113,900.  The  amount  of  inter- 
company profits  represented  in  inventories  of  the  sub- 
sidiaries on  hand  on  the  same  date  amounted  to  $20,- 
109,723.39. 

10.  Dividends  of  subsidiary  companies  available  to 
the  parent  company. — The  dividends  received  by  a 
holding  company  on  the  stock  of  subsidiaries  which  it 
owns  may  not  in  all  cases  be  properly  credited  to  the 
surplus  account  of  the  former.  In  many  instances 
the  subsidiaries  whose  stocks  were  acquired  possessed 
a  surplus  at  the  time  of  consolidation.  The  price 
that  the  holding  company  paid  for  the  stock  of  the 
subsidiary  implied  the  existence  of  such  surplus.  If, 
for  example,  the  capitalization  of  a  subsidiary  com- 
pany amounted  to  $100,000  with  an  accumulated  sur- 
plus of  $30,000  the  purchase  price  of  a  $100  share  in 
such  a  company  would  probably  be  about  $130  per 
share.     If  the  stock  were  purchased  by  the  holding 


SURPLUS,  RESERVES  AND  DIVIDENDS     201 

company  at  this  price,  it  would  appear  in  its  invest- 
ment account  at  a  value  of  $130,000. 

Let  us  assume  that  the  holding  company  increases 
its  surplus  account  to  $50,000  during  the  next  year, 
and  that  the  board  of  directors  votes  to  distribute  the 
entire  surplus  as  a  cash  dividend.  The  parent  com- 
pany is  the  sole  stockholder  and  receives  a  check  from 
the  subsidiary  company  for  $50,000.  But  not  all  of 
this  amount  is  to  be  considered  by  the  holding  com- 
pany as  income.  Only  that  portion  of  the  dividend 
which  represents  a  distribution  of  surplus  profits  earned 
since  the  stock  was  acquired  can  be  treated  as  earn- 
ings. The  reason  is  that  the  distribution  of  the  en- 
tire surplus  in  the  form  of  a  dividend  has  reduced  the 
value  of  the  capital  stock  of  the  subsidiary  to  a  book 
value  of  approximately  $100  a  share.  Consequently 
the  value  of  the  holding  company's  investment  has 
been  reduced  to  $100,000.  Inasmuch  as  this  invest- 
ment is  carried  on  the  books  of  the  holding  company 
at  $130,000,  it  is  clear  that  the  dividend  of  $50,000 
that  is  received  by  the  holding  company  must  be 
divided  into  two  parts,  viz.,  $30,000  to  be  credited  to 
its  investment  account — this  will  reduce  that  account 
to  $100,000;  and  $20,000  to  be  credited  to  its  surplus 
account. 

11.  Surplus  from  sale  of  fixed  assets. — Surplus  re- 
sults from  the  sale  of  fixed  assets  when  any  portion  of 
the  fixed  property  is  sold  for  an  amount  greater  than 
the  book  value  of  that  property.  Sales  of  this  char- 
acter may  be  broadly  grouped  in  two  classes:  sales 


202     FINANCIAL  AND  BUSINESS  STATEMENTS 

of  isolated  units,  and  sales  of  magnitude,  in  which  the 
property  disposed  of  consists  of  an  integral  part  of 
the  operating  equipment. 

Before  a  decision  is  made  in  regard  to  the  disposi- 
tion of  such  profits  it  is  necessary  to  inquire  whether 
or  not  proper  provision  has  been  made  for  the  de- 
preciation of  the  remaining  units  of  equipment.  The 
fact  that  a  profit  has  been  realized  upon  the  sale  of  an 
isolated  unit  of  the  plant  equipment  is  not  an  indica- 
tion that  a  true  profit  has  been  realized.  The  price  paid 
by  the  new  owner  might  represent  elements  other  than 
true  value.  For  example,  an  undertaking  engaged  in 
the  manufacture  of  wTar  munitions  might  pay  a  high 
price  for  a  plant  particularly  suited  to  its  needs,  in 
order  to  fill  a  contract  which  it  would  be  unable  to 
accept  without  securing  such  a  plant.  But  if  inves- 
tigation shows  that  the  proper  provision  for  deprecia- 
tion on  the  remaining  units  has  been  made,  the  profit 
can  undoubtedly  be  credited  to  the  surplus  account. 
It  is,  however,  more  conservative  to  credit  the  amount 
of  the  profit  to  the  reserve  for  depreciation  provided 
on  the  remaining  units. 

Sales  of  magnitude  may  be  illustrated  by  the  case 
of  a  company  engaged  in  manufacturing  office  desks 
and  chairs,  which  maintains  a  separate  establishment 
for  the  manufacture  of  each  article.  Let  us  suppose 
that  the  company  decides  to  discontinue  the  manu- 
facture of  desks  and  to  concentrate  its  energies  upon 
the  manufacture  of  chairs.  If  the  entire  plant  used 
in  the  manufacture  of  desks  is  disposed  of  at  a  profit, 


SURPLUS,  RESERVES  AND  DIVIDENDS     203 

and  if  the  accrued  depreciation  on  the  remaining 
equipment  is  adequate,  the  entire  profit  that  is  real- 
ized may  be  properly  credited  to  the  surplus  account. 
Such  profits  do  not,  however,  constitute  an  addition  to 
the  current  income  account  of  the  company,  and 
should  therefore  appear  as  surplus  adjustments. 

12.  Profits  resulting  from  the  sale  of  investments. 
— Business  firms  from  time  to  time  acquire  invest- 
ments in  the  securities  of  other  companies.  If  such 
holdings  subsequently  are  disposed  of  at  a  profit  it  is 
proper  to  credit  the  surplus  account.  It  is  assumed 
that  the  company  will  have  provided  a  reserve  for  the 
decrease  in  the  value  of  any  other  investments  of  this 
character  that  it  may  have.  If  this  has  not  been 
done,  it  would  be  better  to  credit  the  profit  realized 
on  the  sale  of  investments  to  a  properly  designated 
reserve  account,  since  in  this  way  the  loss  sustained 
on  other  investments  may  be  offset. 

13.  Profits  resulting  from  revaluation  of  fixed 
assets. — It  may  be  necessary  or  advisable  for  a  board 
of  directors  to  revalue  the  fixed  assets.  No  matter 
how  carefully  a  company  may  attempt  to  determine 
in  advance  the  proper  allowances  for  depreciation,  the 
estimates  are  often  incorrect.  If  the  property  has 
been  revalued  by  a  competent  appraiser,  there  is  prob- 
ably no  objection  to  showing  the  increased  value  on 
the  books.  On  the  other  hand,  conservative  account- 
ing practice  often  suggests  another  disposition  of  the 
matter.  At  times  it  is  preferable  to  allow  the  values 
to  remain  unchanged  rather  than  to  swell  the  surplus 

XXII— 15 


204     FINANCIAL  AND  BUSINESS  STATEMENTS 

account  by  credits  due  to  revaluation.  As  the  depre- 
ciation charges  for  subsequent  periods  may  be  re- 
duced, this  method  has  all  the  advantages  and  none  of 
the  defects  of  the  other. 

Evidently,  if  the  appraisal  should  reveal  the  fact 
that  the  property  has  been  overvalued,  the  surplus 
account  should  be  charged  with  the  amount  of  the 
overvaluation.  It  is  also  clear  that  the  revaluation 
should  be  made  in  good  faith,  and  not  for  the  purpose 
of  wiping  out  a  deficit  from  operation.  In  some 
instances  a  corporation  will  acquire  the  physical  prop- 
erty of  a  business  undertaking  by  giving  in  payment 
an  amount  of  capital  stock  in  excess  of  the  value  at 
which  the  assets  stood  on  the  books  of  the  vendor. 
The  difference  between  the  cost  price  to  the  purchaser 
and  the  book  value  of  the  assets  may  be  debited  to  the 
good- will  account  of  the  purchaser;  or  the  board  of 
directors  may  place  upon  the  assets  acquired,  new 
valuations  that  will  absorb  the  excess  price  paid. 

The  practice  of  concealing  the  value  of  the  in- 
tangible property  purchased  has  been  strongly  con- 
demned, and  it  is  interesting  to  note  that  some  cor- 
porations have  altered  their  accounts  so  as  to  disclose 
in  their  balance  sheets  the  value  of  the  intangible 
property.  The  subject  is  discussed  in  an  interesting 
manner  in  an  article  in  the  Journal  of  Accountancy 
(August,  1916)  in  which  the  author  gives  a  list  of 
the  corporations  that  now1  state  separately  the  values 
of  intangible  assets. 

14.  Entries  on   revaluation  necessary   to   adjust 


SURPLUS,  RESERVES  AND  DIVIDENDS      £05 

property  accounts. — If  the  depreciation  of  prior 
periods  was  credited  directly  to  the  asset  account,  the 
increase  in  value  shown  by  the  appraisal  should  be 
debited  to  the  asset  account ;  this  would  make  it  agree 
with  the  appraised  value.  The  credit  should  be  made 
to  surplus  account.  If,  however,  the  depreciation  of 
prior  periods  was  carried  in  a  reserve  account,  the 
increase  in  the  book  value  of  the  property  should  be 
effected  by  transferring  as  much  of  the  excess  as  is 
necessary  to  offset  the  excess  credit. 

15.  Value  of  fixed  assets  is  not  affected  by  eco- 
nomic conditions. — The  value  of  the  fixed  assets  that 
a  company  uses  in  its  operations  is  not  affected  by 
economic  conditions.  This  principle  applies  also 
when  the  value  of  fixed  assets  declines,  or  when  the 
cost  of  duplicating  fixed  assets  is  lower  than  the  book 
value  of  the  assets. 

To  illustrate,  we  will  suppose  that  a  company  has 
in  its  equipment  account  a  record  of  five  engine 
lathes  which  cost  $400  each,  and  on  each  of  which 
depreciation,  based  upon  the  normal  life  of  such  ma- 
chinery, has  accrued  to  the  amount  of  $100.  The 
fact  that  lathes  of  this  kind  can  now  be  purchased  in 
the  open  market  for  $275  each,  owing  to  the  decline 
in  material  and  labor  cost,  would  not  justify  the  com- 
pany in  reducing  the  value  of  the  lathes  upon  its 
ledger.  This  is  true  so  long  as  the  lathes  are  serving 
the  purpose  for  which  they  were  purchased,  and  so 
long  as  the  depreciation  rate  is  sufficient  to  take  care 
of  the  amortization  of  the  assets  to  residual  value  at 


206     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  expiration  of  their  effective  life.  This  being  the 
case,  changes  in  value,  that  are  the  result  of  economic 
conditions  should  be  ignored. 

16.  Entries  to  record  increase  due  to  economic 
causes. — It  is  not  considered  good  accounting  or 
financial  practice  to  swell  the  surplus  account  with 
profit  resulting  from  economic  causes.  If  it  is  de- 
sired to  give  expression  to  the  fact  that  the  fixed 
assets  have  increased  in  value  because  of  economic 
changes,  the  amount  of  the  increase  should  be  cred- 
ited to  an  account  "Reserve  for  Appreciation,"  and 
not  to  the  surplus  account.  Otherwise,  stockholders 
would  be  misled  into  the  belief  that  the  dividends 
which  they  are  receiving  are  a  part  of  the  earned  sur- 
plus. It  is  true,  however,  that  a  corporation  may 
legally  reflect  such  increased  valuation  in  its  surplus 
account,  and  by  disposing  of  an  amount  of  capital 
stock  for  cash,  equivalent  to  the  increase  in  value,  it 
may  distribute  the  cash  in  the  form  of  a  dividend. 
But  even  in  this  procedure,  fairness  to  the  stock- 
holders requires  that  notice  be  given  as  to  the  source 
of  the  dividends. 

REVIEW 

Define  surplus  and  distinguish  between  the  several  kinds  of 
surplus. 

In  what  different  ways  can  surplus  arise? 

How  do  inter-company  profits  on  inventory  affect  the  calcula- 
tion of  surplus? 

When  is  it  proper  to  create  surplus  by  revaluation  of  fixed 
assets?  What  attention  should  be  given  to  changes  in  economic 
conditions  in  valuing  assets? 


CHAPTER  XV 

SURPLUS,  RESERVES  AND  DIVIDENDS   (Continued) 

1.  Surplus  contributed  at  the  time  of  incorpora- 
llon% — Banking  corporations  and  similar  institutions 
very  often  sell  their  initial  issue  of  capital  stock  at  a 
premium  in  order  that  they  may  begin  business  with 
a  surplus.  The  amount  of  the  premium  will  ordi- 
narily be  credited  to  surplus  account  and  the  ordi- 
nary profits  from  operation  will  be  carried  to  an  un- 
divided profits  account.  From  time  to  time  the 
balance  standing  to  the  credit  of  the  surplus  account 
may  be  further  augmented  by  certain  amounts  trans- 
ferred from  the  undivided  profits  account. 

This  does  not  hold  true  in  case  of  industrial  or 
transportation  corporations.  Railroads,  for  instance, 
under  the  jurisdiction  of  the  Interstate  Commerce 
Commission,  are  required  to  credit  the  premium  real- 
ized in  this  manner  to  a  permanent  surplus  account 
suitably  designated. 

In  the  re-organization  of  industrial  corporations 
the  newly  organized  company  may  acquire  the  assets 
of  the  old  company,  in  exchange  for  issues  of  stocks 
and  bonds.  The  par  value  of  these  stocks  or  bonds 
may  be  considerably  less  than  the  fair  value  of  the 
assets   acquired.     In  this   event,   if   the   assets   are 

207 


208     FINANCIAL  AND  BUSINESS  STATEMENTS 

placed  on  the  ledger  of  the  new  company  at  their  bulk 
value,  a  surplus  will  be  created  equal  to  the  difference 
between  the  value  of  the  assets  acquired  and  the  par 
value  of  the  securities. 

Surplus  may  also  be  created  in  the  case  of  re- 
organization by  reducing  the  par  value  of  the  out- 
standing stock  by  an  amount  more  than  sufficient  to 
wipe  out  the  impairment  of  capital. 

2.  Distribution  of  initial  surplus. — Surplus  created 
in  any  of  these  ways  should  not  be  distributed  in  the 
form  of  ordinary  dividends.  Such  action  would 
either  defeat  the  purpose  for  which  it  was  created  or 
would  result  in  misleading  stockholders  who  were  not 
aware  of  the  source  of  the  dividends.  It  is  always 
advisable  when  a  board  of  directors  votes  to  pay 
ordinary  dividends,  using  for  such  purpose  any  part 
of  the  surplus  created  in  the  manner  described,  that 
the  stockholders  should  be  frankly  advised  of  the  fact. 

3.  Secret  reserves. — Two  common  methods  of  cre- 
ating secret  reserves  are :  ( 1 )  providing  for  a  greater 
reserve  for  depreciation  on  fixed  property  than  condi- 
tions warrant ;  (2)  making  extended  provision  for  bad 
and  doubtful  accounts. 

Banking  institutions  frequently  provide  for  such 
reserves  by  making  an  understatement  of  the  value  of 
their  investments. 

If  items  are  charged  to  a  revenue  account  that 
should  have  been  charged  to  a  capital  account  a  secret 
reserve  is  created.  Similarly,  eliminating  assets  from 
the  balance  sheet  will  establish  a  secret  reserve. 


SURPLUS,  RESERVES  AND  DIVIDENDS      209 

An  overstatement  of  liability  will,  of  course,  re- 
duce the  net  worth  shown  in  the  balance  sheet  and 
correspondingly  reduce  the  surplus,  thereby  creating 
a  secret  reserve.  One  should  be  careful  to  distinguish 
secret  reserve  from  surplus  that  is  the  result  of  a  con- 
servative valuation  of  assets.  Prudence  requires  not 
only  that  assets  be  conservatively  valued,  but  also  that 
all  losses  be  anticipated. 

4.  Purpose  of  secret  reserves, — The  creation  of 
secret  reserves  is  often  practised  for  the  purpose  of 
reducing  the  amount  of  the  visible  surplus  so  as  to 
withhold  the  profits  of  the  business  and,  at  the  same 
time,  prevent  stockholders  from  demanding  distribu- 
tion of  the  true  surplus  in  the  form  of  larger  divi- 
dends. 

Ordinarily,  secret  reserves  constitute  a  source  of 
strength  because  extraordinary  losses  that  could  not 
otherwise  be  taken  care  of  may  be  charged  against 
them.  Moreover,  they  enable  the  directors  of  a  com- 
pany to  know  fairly  definitely  whether  or  not  the  sur- 
plus should  be  retained  in  the  business. 

Another  advantage  of  secret  reserves  is  that  they 
permit  the  maintenance  of  a  uniform  dividend  rate 
over  a  period  of  years.  For  example,  if  depreciation 
on  the  fixed  assets  has  accrued  during  prosperous 
years  at  a  higher  rate  than  is  actually  necessary  for 
the  welfare  of  the  business,  the  company  need  not 
make  any  provision  for  depreciation  when  a  lean  year 
is  encountered.  Thus,  in  a  year  when  earnings  were 
low,  there  would  be  no  necessity  for  providing  for 


210     FINANCIAL  AND  BUSINESS  STATEMENTS 

depreciation.  The  secret  reserve  could  be  drawn 
upon  and  all  the  earnings  of  the  period  would  be 
available  for  dividends.  The  declaration  of  a  uni- 
form dividend  rate  over  a  definite  period  of  years 
results  generally  in  the  establishment  of  uniform 
prices  for  the  securities  of  the  company  in  the  open 
market. 

5.  Other  purposes  of  secret  reserves. — Public  serv- 
ice corporations  sometimes  create  secret  reserves  for 
the  purpose  of  reducing  the  surplus  so  as  to  avoid 
agitation  on  the  part  of  the  public  for  a  reduction  of 
rates.  Certain  states  have  now  adopted  a  uniform 
system  of  accounts — a  system  that  effectually  pre- 
vents this  practice.  But  the  uniform  system  of 
accounts  does  not  prevent  utility  corporations  from 
making  charges  to  revenue,  contrary  to  the  estab- 
lished regulations,  unless  the  capital  accounts  are 
thoroly  audited  by  a  commission. 

The  principal  objection  to  a  secret  reserve  is  the 
fact  that  it  is  just  as  incorrect  from  an  accounting 
standpoint  to  undervalue  assets  as  it  is  to  overvalue 
them.  Then,  too,  a  secret  reserve  offers  a  temptation 
to  managers  to  utilize  this  means  of  concealing  losses 
due  to  speculation  or  mismanagement.  Further- 
more, a  secret  reserve  is  sometimes  the  cause  of  injus- 
tice to  stockholders  who  may  dispose  of  their  stock 
for  less  than  its  actual  value,  because  the  board  of 
directors  has  never  informed  them  of  the  presence 
of  the  secret  reserve.  And  finally,  there  is  the  ob- 
jection that  it  is  impossible  to  prepare  true  com- 


SURPLUS,  RESERVES  AND  DIVIDENDS      211 

parisons  of  valuation  or  of  earnings  from  the  reports 
of  a  company  that  has  a  secret  reserve. 

6.  Propriety  vs.  impropriety  of  secret  reserves. — 
While  the  propriety  of  creating  a  secret  reserve  is  to 
be  questioned  for  the  reasons  that  have  been  men- 
tioned, many  conservative  companies  provide  for  it. 
Furthermore,  conservative  business  men  countenance 
the  practice,  provided  it  is  kept  within  reasonable 
limits.  In  the  last  analysis,  it  would  seem  that  if  the 
purpose  of  the  secret  reserve  is  good  and  the  directors 
of  the  company  are  honest,  no  great  harm  can  re- 
sult. 

7.  Disposition  of  the  surplus. — As  the  reader 
already  knows  the  surplus  of  a  company  may  be  dis- 
tributed in  the  form  of  dividends  and  it  may  be  re- 
invested in  the  property.  Surplus  in  the  form  of 
dividends  may  be  distributed  as  cash,  as  capital  stock, 
or  as  assets. 

An  example  of  the  distribution  of  surplus  in  the 
form  of  assets  occurred  recently  in  the  case  of  a  well 
known  powder  manufacturing  company  which  dis- 
tributed dividends  in  the  form  of  Anglo-French 
bonds. 

Re-investment  of  surplus  in  the  property  may  be 
made  in  the  form  of  specific  investment  or  general  in- 
vestment. If  the  surplus  is  invested  either  in  special 
funds  or  in  fixed  property,  it  is  usually  so  ear-marked. 
If  the  surplus  has  not  been  invested  in  funds  or  in 
fixed  property,  it  is  generally  represented  in  all  of 
the  assets. 


212     FINANCIAL  AND  BUSINESS  STATEMENTS 

8.  Surplus  does  not  necessarily  mean  cash. — Cur- 
rent profits  are  usually,  altho  not  always,  represented 
by  cash  or  other  liquid  assets.  The  fact  that  a  com- 
pany has  a  surplus  is  not  always  an  indication  that  it 
is  able  to  pay  its  debts.  If  the  quick  assets  are  not 
sufficient  to  enable  the  company  to  meet  its  maturing 
obligations,  it  may  be  forced  into  the  hands  of  a  re- 
ceiver, even  tho  it  has  a  surplus.  It  is  therefore 
important  to  bear  in  mind  that  the  needs  of  a  corpora- 
tion, as  regards  the  liquid  assets,  largely  govern  both 
the  management  and  the  distribution  of  the  surplus. 

9.  Distribution  of  dividends. — The  basic  principle 
of  a  business  organization  is  that  it  shall  make  money 
for  its  investors.  The  profits  of  a  company,  as  repre- 
sented by  the  surplus,  are  distributed  wholly  or  in 
part  as  dividends.  Upon  the  declaration  of  a  divi- 
dend by  the  board  of  directors,  mention  is  made  on 
the  books  of  the  company,  charging  dividends  de- 
clared and  crediting  them  to  a  dividend  payable  ac- 
count. This  is  done  in  order  to  reflect  the  liability 
of  the  company  to  its  stockholders.  The  dividend 
payable  account  is  closed  out  when  the  cash  is 
actually  paid  to  the  stockholders  in  which  case  the 
dividend  payable  account  is  charged  and  the  cash  is 
credited. 

10.  Characteristics  of  a  dividend. — A  dividend,  to 
be  legal,  must  be  declared  by  the  board  of  directors, 
or  issued  with  the  consent  of  all  the  stockholders. 
After  a  dividend  has  been  declared,  and  notice  of  the 
declaration  has  been  made  public,  it  becomes  a  debt  of 


SURPLUS,  RESERVES  AND  DIVIDENDS      213 

the  corporation  and  should  appear  in  the  balance 
sheet  among  the  current  liabilities. 

In  a  large  corporation,  because  there  are  a  great 
many  stockholders,  a  resolution  of  the  board  some- 
times provides  that  the  transfer  books  shall  be  closed 
at  a  definite  date,  and  that  they  shall  not  be  re- 
opened until  a  later  date  specified  in  the  reso- 
lution. The  object  of  this  is  to  allow  the  office  force 
time  to  draw  the  dividend  checks  as  well  as  to  make 
it  possible  to  ascertain  who  are  the  stockholders  of 
record. 

Dividends  are  declared  as  a  percentage  upon  out- 
standing capital  stock  and  each  stockholder  receives 
payment  according  to  the  amount  of  stock  he  holds. 
Dividends  must  be  paid  out  of  earned  profits.  It  is 
not,  however,  always  an  easy  matter  to  determine  just 
what  is  meant  by  earned  profits  and  the  question  has 
constantly  been  a  fruitful  source  of  litigation.  The 
stock  corporation  laws  of  some  states  provide  sub- 
stantially that  the  directors  of  a  corporation  shall  not 
pay  dividends  except  from  the  surplus  arising  from 
the  business  of  the  corporation.  Furthermore,  they 
shall  not  divide,  withdraw,  or  in  any  way  pay  to  the 
stockholders,  any  part  of  the  capital  of  the  corpora- 
tion or  reduce  the  capital  stock  except  in  the  manner 
provided  by  law.  Where  this  system  is  in  effect, 
heavy  penalties  are  assessed  against  any  director  who 
votes  for  the  illegal  payment  of  a  dividend  as  well  as 
against  any  who  do  not  definitely  indicate  their  dis- 
sent. 


214     FINANCIAL  AND  BUSINESS  STATEMENTS 

11.  Considerations  affecting  the  declaration  of 
dividends. — The  payment  of  a  dividend  involves  the 
distribution  of  liquid  assets  and  therefore  weakens  the 
financial  position  of  a  company.  Prior  to  the  dec- 
laration and  payment  of  the  dividends,  the  directors 
will  probably  consider  whether  or  not  the  company 
can  safely  reduce  its  liquid  assets  for  this  purpose. 
If  it  has  adopted  a  policy  of  expansion,  which  involves 
a  large  increase  in  capital  or  bonded  debt,  or  if  it  must 
soon  meet  a  large  maturing  obligation,  the  directors 
will  probably  be  conservative  and  withhold  dividends. 
They  will,  perhaps,  distribute  a  stock  dividend  thus 
enabling  the  stockholders  to  realize  on  the  accrued 
profits  by  the  sale  of  stock  so  distributed. 

Upon  analysis  it  will  be  seen  that  the  distribution 
of  a  stock  dividend  is  equivalent  to  the  sale  for  cash 
of  new  stock  by  the  company  and  the  subsequent  dis- 
tribution of  the  surplus  in  the  form  of  a  cash  dividend. 

12.  Capital  expenditures  charged  against  surplus. 
— A  wise  financial  policy  will  dictate  a  reinvestment 
of  a  portion  of  the  surplus  in  fixed  property.  There 
are  certain  classes  of  equipment  essential  to  a  cor- 
poration which  are  proper  charges  to  a  capital 
account,  but  from  these  the  corporation  will  not  be 
able  to  derive  additional  earnings  equivalent  to  the 
interest  on  the  money  invested.  Such  equipment 
should  properly  be  financed  out  of  surplus.  The  in- 
vestment of  surplus  in  fixed  property  prevents  the 
sale  of  additional  stocks  or  bonds.  There  is  a  conse- 
quent saving  in  interest  charges  or  dividend  disburse- 


SURPLUS,  RESERVES  AND  DIVIDENDS      215 

ments  which  reacts  ultimately  to  the  benefit  of  the 
stockholders.  The  investment  of  surplus  in  fixed 
property  also  enhances  the  value  of  the  capital  stock. 

13.  Reserves  created  out  of  surplus. — A  corpora- 
tion may  set  aside  a  portion  of  its  surplus  for  the  pur- 
pose of  establishing  a  pension  fund.  If  it  does,  it 
will  be  obliged  to  charge  the  surplus  account  and  to 
credit  a  pension  reserve  account  with  the  amount  set 
aside.  An  equivalent  amount  of  cash  or  assets  might 
be  reserved  in  a  special  fund  known  as  the  pension 
fund — out  of  which  pensions  could  be  paid  to  the  em- 
ployes of  the  company.  Other  special  reserves  might 
from  time  to  time  be  created  if,  in  the  judgment  of 
the  board  of  directors,  it  were  wise  to  do  so. 

14.  Reserve  account  misnamed. — Attention  has 
already  been  called  to  the  fact  that  some  reserve 
accounts,  such  as  reserve  for  depreciation  or  reserve 
for  doubtful  debts,  are  not  a  part  of  surplus.  Oc- 
casionally we  find  on  balance  sheets  an  account  called 
reserve  for  taxes  or  reserve  for  unearned  income. 
The  former  is  a  liability  and  should  appear  among 
the  current  liabilities,  while  the  latter  is  a  deferred 
credit  to  income  and  should  not  be  stated  with  the 
true  reserve. 

15.  Illegal  dividends. — The  reader  has  noted  that 
dividends  can  be  declared  lawfully  in  the  form  of 
cash,  stock  or  otherwise.  The  declaration  of  an 
illegal  dividend  or  the  payment  of  an  illegal  dividend 
already  declared  may  be  enjoined  and  stopped  by 
proper  action  of  the  stockholders. 


216     FINANCIAL  AND  BUSINESS  STATEMENTS 

Illegal  dividends  may  be  of  three  types: 

1.  Those  declared  in  disregard  of  the  rights  of  some 
stockholders;  for  example,  declaring  dividends  on 
common  stock  altho  cumulative  preferred  dividends 
have  not  been  paid. 

2.  Those  declared  in  violation  of  the  charter  or 
by-law  provisions  of  the  particular  corporation.  Such 
a  provision  might  state  that  a  given  amount  must  be 
accumulated  in  surplus  before  a  dividend  can  be  de- 
clared. 

3.  Those  which  either  impair  the  capital  stock  or 
threaten  the  solvency  of  the  corporation. 

16.  Scrip  dividends. — Scrip  dividends  really  par- 
take of  the  nature  of  a  forced  loan.  Stockholders 
would  undoubtedly  prefer  to  have  their  dividends 
distributed  in  cash,  but,  if  the  corporation  issues  scrip 
to  them,  they  are  compelled  to  accept  it.  Of  course, 
they  can  realize  the  scrip  in  cash  by  selling  it  in  the 
market,  but  if  this  is  done  the  scrip  usually  sells  for 
much  less  than  its  face  value. 

17.  Dividend  policies. — The  wise  executive  at- 
tempts to  forecast  not  only  the  immediate,  but  also 
the  distant  future.  If  it  appears  that  a  business  will 
need  to  add  to  its  facilities  in  order  to  take  care  of 
an  increasing  volume  of  business,  the  management 
would  probably  wish  to  withhold  part  of  the  profits 
from  distribution.  The  investment  of  the  surplus  or 
a  portion  of  it  in  fixed  property  will  have  the  effect  of 
counteracting  any  mistake  the  management  may 
have  made  in  charging  its  expenditures  to  capital. 


SURPLUS,  RESERVES  AND  DIVIDENDS      217 

Furthermore,  the  retention  of  the  surplus  for  invest- 
ment in  fixed  property  is  tantamount  to  charging  the 
expenditures  directly  against  revenue. 

Whether  or  not  all  or  part  of  the  surplus  should 
be  distributed  in  the  form  of  dividends  will  require 
careful  consideration  of  many  factors.  Summarized 
they  are  as  follows: 

1.  Can  the  business  safely  reduce  its  liquid  assets 
by  the  amount  necessary  to  pay  the  dividends? 

2.  Is  the  margin  between  selling  price  and  cost  de- 
creasing to  such  an  extent  as  to  threaten  the  profits 
enjoyed  in  the  past? 

3.  Have  all  expenditures  for  capital  accounts  been 
justified  and  have  they  been  bona  fide  expenditures? 

4.  What  is  the  company's  credit  position  and  its 
ability  to  raise  needed  sums  for  expansion  thru  the 
issue  of  capital  stock  or  bonds? 

5.  Is  the  investment  market  favorable? 

6.  Can  the  profits  safely  stand  increased  fixed 
charges  or  increased  amounts  for  dividend  distribu- 
tion? 

REVIEW 

Under  what  circumstances  is  surplus  contributed  directly  by 
investors  and  what  is  the  object  in  so  doing? 

How  are  secret  reserves  established  and  what  purposes  do 
they  serve? 

How  is  the  surplus  distributed  to  stockholders?  What  differ- 
ent forms  of  dividends  are  used? 

What  are  the  chief  characteristics  of  a  sound  dividend  policy? 


CHAPTER  XVI 

SINKING  FUNDS  AND  OTHER  FUNDS 

1.  The  theory  of  the  sinking  fund. — Corporate 
bondholders  require  the  assurance  that  the  amount 
due  to  them  will  be  paid  at  maturity.  To  accomplish 
this,  the  indenture  provides  that  a  certain  annual  sum 
shall  be  set  aside  at  periodic  intervals,  which  when 
invested  and  reinvested  at  an  assumed  rate  of  interest, 
will  amount  to  the  principal  of  the  debt  at  the  ma- 
turity thereof.  The  fund  set  aside  is  usually  placed 
in  the  hands  of  trustees,  a  trust  company  ordinarily 
being  designated  for  this  purpose.  Detailed  pro- 
visions are  made  in  the  indenture  with  reference  to 
the  investment  of  the  fund  and  the  retirement  of  the 
debt.  The  phraseology  used  in  the  majority  of  in- 
dentures, "the  sinking  fund  shall  be  set  aside  out  of 
profits"  necessitates  a  charge  against  revenue  and  a 
credit  to  a  sinking  fund  reserve  for  the  amount  of  the 
instalment.  At  the  same  time  an  equivalent  amount 
of  cash  or  other  assets  is  set  aside  out  of  the  general 
funds  of  the  company.  When  the  bonds  mature,  the 
sinking  fund  investments  are  converted  into  cash  and 
the  cash  used  to  retire  the  indebtedness.  The  inden- 
ture frequently  provides  that  the  sinking  fund  shall 
be  invested  in  the  very  bonds  which  are  to  be  re- 

218 


SINKING  FUNDS  AND  OTHER  FUNDS      219 

deemed;  the  agreement  may  also  stipulate  the  price 
to  be  paid  in  repurchasing  the  bonds.  In  some  cases 
the  bonds  which  are  to  be  retired  from  the  fund  are 
drawn  by  lot,  and  cease  to  bear  interest  after  the  date 
of  drawing.  It  will  be  seen,  therefore,  that  the  sink- 
ing fund  reserve  has  simply  served  the  purpose  of 
withholding  from  stockholders  a  certain  portion  of 
the  profits  during  the  life  of  the  bonds,  and  that  after 
the  retirement  of  the  bonds  it  reverts  to  surplus,  from 
which  it  was  originally  created. 

2.  The  sinking  fund  reserve  a  charge  against 
profits. — The  sinking  fund  reserve  practically  oper- 
ates as  a  depreciation  reserve,  by  compelling  the  cor- 
poration to  reinvest  a  certain  portion  of  its  profits 
in  assets.  The  setting  aside  of  the  cash  in  the  sink- 
ing fund  constitutes,  in  its  last  analysis,  a  partial 
payment  on  the  debt.  The  profits  represented  by  the 
sinking  fund  reserve  will  ultimately  find  their  way 
into  fixed  property  investment,  and  thus  serve  to  keep 
intact  the  original  investment  of  the  company. 
Therefore,  if  the  sinking  fund  reserve  is  large  enough 
to  take  care  of  the  accrued  depreciation  on  physical 
property,  the  company  is  under  no  compulsion  to  pro- 
vide in  addition  a  reserve  for  depreciation.  If  both 
reserves  have  been  created  simultaneously,  income  has 
been  charged  twice  for  the  same  thing. 

Inasmuch  as  depreciation  is  a  legitimate  charge 
against  the  current  income  account,  contributions  to 
the  sinking  fund  reserve  are  a  charge  against  income 
if  no  depreciation  reserve  is  provided.     If,  however, 

XXII— 16 


220    FINANCIAL  AND  BUSINESS  STATEMENTS 

a  depreciation  reserve  is  also  created,  contributions  to 
the  sinking  fund  reserve  should  be  charged  against 
surplus,  and  not  against  current  earnings.  It  will 
be  seen,  too,  that  where  both  kinds  of  reserves  are 
created,  the  depreciation  reserve  will  provide  for  the 
loss  in  physical  assets,  which  are  due  to  wear  and  tear, 
while  the  sinking  fund  reserve  results  in  an  accumu- 
lation of  profits  represented  by  assets.  The  assets 
will  enable  the  corporation  to  finance  the  necessary 
replacements  of  its  physical  property  out  of  its 
earnings. 

It  is  important  to  note,  in  passing,  that  while  both 
reserves  may  be  created  simultaneously,  they  have 
nothing  in  common,  and  are  accumulated  on  different 
bases. 

3.  Funds  distinguished  from  reserves. — A  fund  is 
an  asset,  and  as  its  name  implies,  consists  of  an 
amount  of  cash  or  other  assets,  set  aside  from  the 
general  funds  of  the  company,  for  a  specific  purpose. 
In  contradistinction  to  a  fund,  a  reserve  is  a  credit 
account  created  by  setting  aside  a  certain  portion  of 
the  profits  or  surplus  for  some  specific  or  general  pur- 
pose. 

Not  infrequently  the  reserve  serves  to  measure  the 
amount  of  its  corresponding  fund.  Thus  a  sinking 
fund  reserve  might  be  set  aside  out  of  profits  or  sur- 
plus by  virtue  of  the  provisions  of  a  mortgage  inden- 
ture, and  at  the  same  time,  cash  or  other  assets  equiv- 
alent to  the  amount  of  the  reserve,  might  be  set  aside 
in  the  sinking  fund. 


SINKING  FUNDS  AND  OTHER  FUNDS      221 

An  insurance  reserve  might  be  created  out  of  rev- 
enue for  the  purpose  of  enabling  a  company  to 
carry  its  own  insurance.  In  this  case  the  reserve 
would  be  created  by  charges  to  operating  expenses. 
At  the  same  time  an  insurance  fund  would  be  created 
so  that  in  event  of  loss  by  fire  the  company  would 
have  the  necessary  cash,  or  its  equivalent,  to  reimburse 
itself.  If  this  reserve  was  not  specifically  invested 
in  assets  such  as  cash  or  securities,  it  might  perhaps 
be  invested  in  the  very  properties  that  would  be  de- 
stroyed by  the  fire.  A  fund,  therefore,  is  always 
an  asset,  while  the  reserve  is  always  a  credit 

4.  Sinking  funds  proper. — A  sinking  fund  is  an 
amount  of  cash  set  aside  for  the  purpose  of  meeting 
some  debt  at  its  maturity.  In  the  creation  of  a  sink- 
ing fund  according  to  scientific  methods,  we  have  a 
problem  consisting  of  one  unknown  and  two  known 
factors.  The  known  factors  are  the  amount  to  be 
accumulated  and  the  number  of  periods  or  instalments. 
The  amount  of  the  periodical  instalment  is  the  un- 
known factor  and  this  is  determined  by  the  rate  of  in- 
terest which  it  is  assumed  will  be  earned  on  the  fund. 
This  is  usually  ascertained  from  compound  interest 

tables. 

When  the  number  of  periods  and  the  rate  of  in- 
terest are  unusual,  the  amount  of  the  sinking  fund 
contribution  can  be  determined  by  the  use  of  loga- 
rithms. 

5.  The  investment  of  the  sinking  fund.— The 
periodical  instalment  set  aside  under  the  provisions 


222     FINANCIAL  AND  BUSINESS  STATEMENTS 

of  the  sinking  fund  agreement  is  usually  paid  over 
to  a  trustee  who  is  charged  with  the  duty  of  safely 
investing  it.  The  trustee  reports  at  regular  inter- 
vals to  the  debtor  corporation.  The  fund  may  be 
invested  in  gilt-edged  securities  or  it  may  be  invested 
in  the  very  bonds  to  be  redeemed,  if  the  latter  can  be 
purchased  under  favorable  conditions. 

6.  Treatment  of  interest  earned  on  the  sinking 
fund. — The  interest  earned  on  the  sinking  fund  in- 
vestment is  a  debit  to  the  sinking  fund  cash  account. 
The  cash  will  be  retained  by  the  trustee  and  used  in 
the  purchase  of  additional  bonds  or  for  investment 
in  other  securities.  The  question  as  to  the  disposition 
of  the  credit  of  the  interest  earned  has  created  some 
discussion.  The  credit  may  be  placed  in  an  account 
called  "interest  earned  on  the  sinking  fund"  and  will 
ultimately  find  its  way  into  surplus.  If  a  sinking 
fund  reserve  has  been  created,  it  would  be  better  to 
credit  the  amount  of  the  interest  earned  directly  to 
the  reserve  account. 

Some  authorities  hold  that  the  interest  earned  may 
be  properly  credited  to  the  interest  paid  on  the  out- 
standing bonds.  The  author  does  not  approve  of  this 
theory  because  the  interest  earned  on  the  sinking  fund 
has  nothing  to  do  with  the  interest  on  the  debt. 

7.  Sinking  fund  and  reserve  fund  investments. — 
The  method  of  treating  sums  set  aside  for  sinking  fund 
purposes  in  the  balance  sheet  has  already  been  dis- 
cussed. It  remains  for  us  to  consider  here,  the  ques- 
tion of  the  valuation  of  securities  in  sinking  funds  and 


SINKING  FUNDS  AND  OTHER  FUNDS      223 

reserve  funds.     Funds  of  this  character  are  usually 
created  in  connection  with  a  reserve  out  of  current 
income  or  surplus.     Thus,   a  sinking  fund  reserve 
might  be  set  up  out  of  income  or  out  of  surplus  and 
an  equivalent  amount  of  cash  set  aside  in  the  sinking 
fund,  which  would  ordinarily  be  invested  in  gilt  edge 
securities.     An  undertaking  might  set  aside  out  of 
its  surplus,  a  reserve  which  would  control  and  meas- 
ure the  amount  of  cash  which  was  set  aside  as  a 
pension  fund.     In  the  same  manner,  an  organization 
that  decided  to  carry  its  own  insurance  may  create  an 
insurance  reserve,  by  charges  against  income,  and  at 
the  same  time,  set  aside  in  an  insurance  fund,  the 
amount  of  cash  which  would  otherwise  have  been  paid 
for  insurance  premiums.     In  other  instances,  how- 
ever, the  funds  are  created  without  setting  aside  a 
portion  of  the  surplus  to  measure  the  amount  thereof. 
It  is  obvious,  of  course,  that  if  the  portion  of  the 
surplus  account  which  has  been  temporarily  locked 
up  in  special  funds  is  not  "ear  marked,"  the  balance 
standing  in  the  surplus  account  is  not  free  surplus. 
Ordinarily  investments  in  special  funds  of  this  char- 
acter will  be  carried  at  cost.     An  increase  in  the  value 
of  the  investments  is  not  available  until  the  same  are 
sold,  and  it  is  not  considered  desirable  to  reflect  in  the 
balance  sheet  fluctuations  in  the  value  of  investments 
carried  in  permanent   funds   of  this   character.     It 
might  be  well,  however,  to  state  in  the  balance  sheet, 
in  a  parenthetical  reference,  the  market  values  of  in- 
vestments carried  in  special  funds.     If  the  invest- 


224     FINANCIAL  AND  BUSINESS  STATEMENTS 

merits  are  sold  and  the  increase  in  value  realized,  tke 
profit  will  be  available  either  for  the  general  purposes 
of  the  organization  or  will  be  added  to  the  funds,  de- 
pending either  upon  the  contractual  obligation  in- 
curred in  the  creation  of  the  fund,  or  in  accordance 
with  the  wishes  of  the  owners. 

If  the  value  of  investments  carried  in  special  funds 
has  decreased,  the  decrease  should  be  reflected  in  the 
reserve  account  or  in  the  surplus  account,  if  it  seems 
to  be  a  permanent  decrease,  or  if  there  is  likelihood 
of  loss  being  sustained  on  the  ultimate  realization  of 
the  investment.  On  the  other  hand,  temporary  fluc- 
tuations may  be  ignored. 

8.  Insurance  funds  should  be  adequate  to  meet 
losses. — In  connection  with  insurance  funds,  it  is 
necessary  to  see  that  the  amount  is  adequate  to  meet 
the  losses  that  might  be  sustained.  When  a  cor- 
poration has  a  number  of  scattered  plants,  the  insur- 
ance protection  need  not  be  so  complete  as  it  would 
have  to  be  if  the  entire  fixed  property  were  located  at 
one  point.  Many  corporations  are  carrying  their 
own  insurance  and  if  the  fire  hazard  is  negligible,  this 
may  be  a  profitable  proceeding.  Xevertheless,  the 
creation  of  a  reserve  for  insurance  without  the  cre- 
ation of  an  accompanying  fund,  which  will  be  in- 
vested in  cash  deposits  or  securities,  wtould  be  danger- 
ous, because  the  reserve  might  be  invested  in  the  very 
assets  which  would  be  destroyed  by  a  fire. 


SINKING  FUNDS  AND  OTHER  FUNDS      225 


REVIEW 

Explain  the  nature  of  a  sinking  fund  and  how  it  is  operated. 

Distinguish  between  reserves  and  funds. 

What  different  methods  of  treating  repurchased  bonds  may- 
be followed  in  the  accounts? 

Describe  the  best  methods  of  dealing  with  reserve  fund  invest- 
ments in  the  accounts. 


CHAPTER  XVII 

RELATION  OF  WORKING  CAPITAL  AND 
INCOME  TO  ASSETS 

1.  Relation  of  net  income  to  capital  stock. — It  is  a 
frequent  custom  in  interpreting  financial  statements 
to  consider  that  the  ratio  existing  between  net  income 
and  capital  stock  is  a  sure  index  of  the  progress  of 
the  business.  While  this  ratio  discloses  the  ability, 
or  lack  of  it,  on  the  part  of  a  corporation  to  pay  a 
dividend,  many  overlook  the  fact  that  capital  stock 
does  not  represent  the  total  invested  assets  of  a  busi- 
ness. In  many  cases,  the  earnings  which  a  corpora- 
tion discloses  in  its  income  statements,  are  due  in  no 
small  measure  to  large  surpluses  and  reserves. 

Commenting  upon  the  balance  sheets  of  four  of  the 
large  Chicago  packing  companies  (Armour,  Cudahy, 
Morris  and  Swift)  a  writer  recently  made  the  state- 
ment that  for  the  year  1915  the  companies  had  earned 
over  25  per  cent  on  the  total  capital  of  $110,000,000. 
This  statement  is  true,  but  let  us  analyze  the  situ- 
ation a  little  further  for  the  purpose  of  determining 
whether  or  not  it  really  means  anything. 

The  following  table  shows  the  capital  stock,  sur- 
plus, reserves,  bonded  debt  and  current  liabilities  of 
each  organization  as  reported  for  the  year  1915: 

226 


WORKING  CAPITAL,  INCOME  AND  ASSETS     227 

Cudahy 
Armour  $  Co.  Pckg.Co.  Morris  $  Co.  Swift  $  Co. 

Capital  Stock $  20,000,000  $12,000,000  $  3,000,000  $  75,000,000 

Surplus 98,733,117       6,050,270    29,510,270      45,850,000 

Reserves     4,597,356         5,900,884 

■  <  i —  — — -— ~ —~— —~ 

Total  owned  capital. .  .$118,733,117  $18,050,270  $37,107,626  $126,750,884 

Bonds     30,000,000      3,519,000     11,300,000      24,500,000 

Current  Liabilities   52,583,248     17,237,518     10,438,963      56,115,556 

,  1 — 

Total  borrowed  capital. $  82,583,248  $20,756,518  $21,738,963  $  80,615,556 

■ .    V—     

Total  combined  capital.$201,316,365  $38,806,788  $58,846,589  $207,366,440 

2.  Comments  upon  the  above  statement. — It  will 
be  noted  that  the  financial  plans  of  each  of  these 
organizations  differ  widely.  A  comparison  of  the 
capital  stock  account  shows  that  Armour  and  Morris 
have  raised  more  capital  thru  the  issue  of  bonds 
than  thru  sale  of  stock;  Cudahy  and  Swift  on 
the  other  hand  have  raised  more  capital  thru  an 
issue  of  stock  than  thru  the  issue  of  bonded  debt. 
For  the  purpose  of  stating  the  comparison  on  a  more 
uniform  basis,  let  us  consider  the  following  statement, 
which  shows  how  the  capital  owned  and  borrowed  is 
distributed  by  percentage. 

Cudahy 

Armour  fy  Co.    Pckg.Co.  Morris  $  Co.  Swift  fy  Co. 

Capital  Stock 9.93%               30.92%  5.10%  36.17% 

Surplus     49.05                   15.59  50.14  22.11 

Reserves     7.82  2.85 

Total   58.98  46.51  63.06  61.13 

Bonded  debt 14.90  9.07  19.20  11.81 

Current  liabilities   .  26.12  44.42  17.74  27.06 

Total     41.02  53.49  36.94  38.87 

Combined  Total  ...100.00  100.00  100.00  100.00 


228     FINANCIAL  AND  BUSINESS  STATEMENTS 

3.  Ratio  of  net  income  to  capital  stock. — If  we 
calculate  the  ratio  of  net  income  to  capital  stock  in 
each  of  the  individual  companies,  we  learn  that 
Armour's  earnings  for  the  year  1915  were  equivalent 
to  bo  per  cent  on  the  capital  stock,  while  the  earnings 
of  Cudahy,  Morris  and  Swift  were  respectively  6 
per  cent,  77  per  cent  and  18.8  per  cent.  When  the 
financial  writer  made  his  calculations,  he  added  the 
earnings  of  all  the  companies  together  and  divided 
by  the  aggregate  of  the  capital  issues  to  arrive  at  his 
percentage  of  25.65  per  cent.  Yet,  when  we  con- 
sider the  earnings  of  the  individual  companies  with 
reference  to  capital  stock,  we  see  that  the  results  differ 
widely  and  bear  no  relation  to  the  average  determined 
by  the  financial  writer. 

4.  Ratio  of  net  income  to  total  invested  assets. — 
It  will  be  obvious  that  the  total  capital  fund  which 
each  one  of  these  organizations  employed  in  business, 
consists  of  the  total  assets  owned  by  each  organiza- 
tion. This  is  the  capital  fund  which  was  turned  over 
or  employed  in  the  business  organization,  and  with 
which  these  organizations  earned  their  apparently 
enormous  profits.  If  we  calculate  the  ratio  of  net 
income  to  total  assets,  we  learn  that  in  the  case  of 
Armour  &  Company,  the  ratio  is  5.46  per  cent; 
Cudahy  Packing  Company,  1.86  per  cent;  Morris  & 
Co.,  3.94  per  cent. ;  Swift  &  Company,  6.83  per  cent. 
The  average  for  all  companies  combined  is  5.57  per 
cent.  For  the  purpose  of  comparison,  attention  is 
called  to  the  following  table,  showing  the  ratio  of  net 


WORKING  CAPITAL,  INCOME  AND  ASSETS     229 

income  to  capital  stock  and  the  ratio  of  net  income 
to  total  assets  for  all  the  companies: 

Cuddhy 
Armour  $  Co.    Pckg.  Co.      Morris  $  Co.  Swift  %  Co. 

Ratio  of  net  income  to 

capital   stock    55.0  6.03  77.3  18.8 

Average  for  all  companies  25.65% 

Ratio  of  net  income  to 

total  assets    5.46  1.86  3.94  6.83 

Average  for  all  companies  5.57% 

5.  Ratios  based  on  invested  assets  are  the  proper 
ratios  to  employ. — From  a  study  of  the  foregoing 
figures  it  will  be  seen  that  comparisons  on  percentage 
bases  are  apt  to  be  misleading  if  the  proper  basis  is 
not  used.  It  is  clearly  evidenced  in  the  case  of  the 
packing  companies  that  more  significant  comparison 
is  the  ratio  of  net  income  to  total  assets.  When  it  is 
considered  that  the  profits  of  Armour  and  Company 
are  based  on  the  sales  turn-over  of  $425,000,000;  that 
Swift  and  Company's  business  approximated  $500,- 
000,000  while  that  of  the  Cudahy  Company  approx- 
imated $116,000,000,  the  conclusion  necessarily  fol- 
lows that  the  percentage  of  profit  on  sales  is  very 
small,  and  that  an  enormous  turn-over  is  necessary 
to  earn  the  profit  made.  Even  in  making  compari- 
son on  this  basis,  which  is  the  best  one  to  use  for  com- 
parisons of  different  companies,  there  are  a  number 
of  factors  which  are  not  uniform  in  all  cases.  Com- 
parisons would  best  be  made  for  a  series  of  years 
with  respect  to  the  individual  companies  and  the  pro- 
gression or  retrogression  reflected  in  them  noted. 


230     FINANCIAL  AND  BUSINESS  STATEMENTS 

6.  Relation  of  working  capital  to  total  assets. — It 
is  impossible  to  lay  down  any  general  rules  which  will 
aid  in  determining  the  proper  relation  of  working  cap- 
ital to  total  assets.  Perhaps  the  best  rule  is  that  the 
working  capital  should  vary  in  accordance  with  the 
sales.  This  naturally  leads  to  the  question,  "What 
is  working  capital?"  Working  capital  is  commonly 
understood  to  mean  that  portion  of  the  liquid  assets, 
free  and  unpledged,  which  a  firm  has  available  for 
employment  in  the  business.  In  other  words  it  is  the 
excess  of  liquid  assets  over  liquid  liabilities ;  that  por- 
tion of  the  liquid  assets  not  furnished  by  creditors  or 
by  temporary  bank  loans. 

Current  assets  are  usually  acquired  either  thru  the 
parting  with  other  assets  or  by  the  creation  of  addi- 
tional floating  liabilities.  To  ignore  the  floating 
liabilities  is  undesirable,  because  a  large  floating  debt 
is  usually  an  evidence  of  weakness,  and  always  may 
be  a  source  of  danger.  Therefore,  working  capital 
should  be  understood  to  mean  the  excess  of  quick 
assets  over  quick  liabilities. 

7.  Amount  of  working  capital  needed  depends 
upon  nature  of  business. — Just  as  conditions  in  each 
kind  of  business  differ,  so  the  needs  of  individual  con- 
cerns in  any  line  of  business  differ  also.  There  is  no 
doubt  but  that  a  concern  handicapped  by  a  shortage 
of  working  capital  will  not  operate  as  efficiently  as 
one  with  sufficient  working  capital  at  its  disposal. 
Without  proper  working  capital  shortage  of  ma- 
terial, long  credit  with  consequent  loss  of  discounts, 


WORKING  CAPITAL,  INCOME  AND  ASSETS     231 

and  many  other  troubles  will  be  encountered.  The 
shortage  in  working  capital  may  result  from  poor 
managerial  or  financial  policy,  or  from  the  distribu- 
tion of  too  great  a  portion  of  the  profit  in  the  form  of 
dividends.  Even  tho  a  large  profit  has  been  earned 
in  any  given  year  it  should  not  be  distributed  in  the 
form  of  cash  dividends  at  the  expense  of  future  busi- 
ness needs. 

For  example,  a  comparatively  young  undertaking 
which  is  expanding  rapidly,  and  which  is  requiring 
considerable  working  capital  for  the  continuance  and 
expansion  of  its  business,  must  have  a  far  larger 
amount  of  working  capital  than  one  which  is  pro- 
gressing at  a  uniform  rate.  New  business  must  be 
financed  before  the  old  business  has  been  collected 
upon.  A  continual  increase  in  volume  of  business 
throws  a  larger  burden  on  the  concern,  and  necessi- 
tates corresponding  increases  in  the  amount  of  work- 
ing capital. 

8.  No  rule  for  amount  of  quick  assets  required  by 
corporations. — In  conclusion,  it  may  be  said  that 
there  is  no  rule  that  can  be  laid  down  as  to  the  amount 
of  quick  assets  which  a  corporation  should  endeavor 
to  acquire.  In  a  line  of  business  in  which  long  cred- 
its are  given  to  customers,  it  is  evident  that  a  greater 
amount  of  working  capital  will  be  needed  than  in 
those  lines  in  which  shorter  credits  are  given.  More- 
over, if  the  terms  of  credit  received  by  an  undertak- 
ing are  comparatively  short,  and  the  terms  of 
credit   allowed   to   its   customers   are   comparatively 


232     FINANCIAL  AND  BUSINESS  STATEMENTS 

long,  a  greater  amount  of  working  capital  must  be 
provided. 

9.  The  economic  status  of  contributors  of  capital 
to  a  business  enterprise. — Contributors  of  capital 
which  is  employed  in  a  business  enterprise  may  be 
divided  into  four  classes: 

Long-term  creditors,  such  as  bondholders  and  hold- 
ers of  notes  having  more  than  one  year  to  run. 

Short-term  creditors  whose  debts  are  due  in  less 
than  one  year. 

Lessors,  leasing  property  to  a  firm  for  a  term  of 
years,  at  stated  annual  rentals. 

The  investors,  the  sole  owner,  the  partners  or  the 
stockholders  of  a  corporation,  who  have  the  control 
and  management  of  the  organization. 

Creditors  of  the  first  class  have  usually  a  lien  on  the 
fixed  property  of  the  organization,  and  receive  as  com- 
pensation a  stated  sum  which  is  known  as  interest. 
This  class  comprises  those  who  have  had  sufficient  con- 
fidence in  the  managers  of  the  enterprise  to  entrust 
their  capital  to  them,  exacting  a  stated  and  definite 
rate  of  compensation  for  its  use. 

The  second  class  consists  of  those  who,  as  a  rule, 
have  no  security  for  their  claims,  but  who  are  still 
willing  to  advance  their  capital  for  a  limited  period 
to  the  managers.  They  may  receive  compensation 
in  the  way  of  interest  or  their  compensation  may  take 
the  form  of  profits  realized  on  merchandise  sold  to 
the  managers. 

The  third  class  consists  of  those  who  have  had  suf- 


WORKING  CAPITAL,  INCOME  AND  ASSETS     233 

ficient  confidence  in  the  management  and  in  the  enter- 
prise to  give  them  title  to  the  use  of  their  property  for 
a  specified  number  of  years  under  a  lease,  and  who 
have  exacted  compensation  or  their  share  of  the 
profits  of  the  enterprise  in  the  form  of  a  stated  annual 
rental. 

The  last  class  embraces  those  who  have  risked  their 
capital  in  the  business  enterprise  for  the  purpose  of 
reserving  to  themselves  all  of  the  profits  that  result 
after  their  fellow-contributors  in  the  business  enter- 
prise have  been  paid  their  stated  sums. 

10.  Is  interest  on  capital  part  of  cost  of  produc- 
tion?— The  realization  of  the  foregoing  facts  in  their 
full  significance  will  do  more  than  anything  else  to 
clear  up  the  subject  of  charging  interest  on  capital 
as  a  part  of  the  cost  of  production.  The  reader  will 
have  noted  in  the  Text  on  "Cost  Finding"  that  many 
engineers  and  accountants  favor  the  method  of  charg- 
ing interest  on  capital  as  a  part  of  the  cost  of  produc- 
tion. The  author  holds  that  excepting  for  statistical 
purposes  this  practice  is  entirely  incorrect  in  prin- 
ciple, for  the  following  reasons: 

From  an  economic  standpoint  the  entire  profit  of 
a  business  after  the  first  three  classes  of  contributors 
to  an  enterprise  mentioned  on  page  232  have  been 
paid,  is  profit  from  business  operations.  The  capital 
employed  by  the  managers  in  the  venture  cannot  earn 
two  kinds  of  income,  viz.,  interest  and  profit. 

The  charge  for  interest  on  invested  capital  as  a  part 
of  the  cost  of  production  necessitates  a  bookkeeping 


234     FINANCIAL  AND  BUSINESS  STATEMENTS 

entry  of  a  debit  to  interest  expense  account,  and  a 
credit  to  an  interest  earning  account.  These  entries 
cancel  each  other  in  the  profit  and  loss  summary,  so 
the  net  result  as  far  as  the  ultimate  profit  is  con- 
cerned is  the  same  whether  the  entry  has  been  made 
or  not.  There  is  this  important  difference,  however; 
a  fictitious  entry  has  been  made  in  the  account  for 
interest  expense  that  will  never  be  paid  in  cash,  and 
for  an  interest  income  that  will  never  be  realized  in 
cash.  Moreover,  interest  on  capital  investment, 
being  charged  as  a  part  of  the  cost  of  production,  will 
load  the  cost  of  production  with  an  element  of  ex- 
pense for  which  no  liability  has  been  incurred  and 
for  which  a  direct  outlay  in  cash  will  never  be  required. 

11.  Difficulty  of  selecting  correct  rate. — Even  if  it 
were  assumed  that  the  principle  under  discussion  is 
correct,  there  is  still  another  difficulty  to  be  confronted 
in  selecting  a  rate  of  interest.  It  is  just  as  reasonable 
to  select  four  per  cent  as  it  is  eight  per  cent,  but  one 
can  readily  see  that  the  computed  cost  would  be  dif- 
ferent in  different  organizations  if  the  same  rate  of 
interest  were  not  selected  in  both. 

If  interest  is  to  be  charged  for  the  use  of  capital 
the  time  element  must  be  considered  and  the  charge 
must  be  made  only  for  the  exact  time  that  the  money 
has  been  employed  in  production.  The  calculations 
involved  in  this  would  be  an  almost  impossible  prop- 
osition from  a  bookkeeping  standpoint. 

The  manner  in  which  capital  is  provided  cannot 
possibly  affect  the  cost  of  production,  for  the  methods 


WORKING  CAPITAL,  INCOME  AND  ASSETS     235 

of  financing  a  business  have  no  connection,  direct  or 
indirect,  with  the  cost  of  making  the  product. 

12.  Inflation  of  inventory  values, — One  particu- 
larly objectionable  feature  in  charging  interest  as 
a  part  of  the  cost  of  production  is  that  such  a  charge 
results  in  inflating  inventory  values.  If  these  values 
are  allowed  to  remain  on  the  balance  sheet,  part  of  the 
profits  will  be  anticipated  to  the  extent  that  the  in- 
ventory value  includes  this  specific  charge  for  interest. 
Therefore  a  concern  that  follows  this  practice  com- 
mences to  take  its  profit,  weeks  or  months,  perhaps, 
before  the  goods  are  offered  for  sale.  This  practice 
would  have  a  tendency  to  imperil  the  credit  of  any 
concern  that  engages  in  it,  because  a  banker  who  is 
approached  for  the  purpose  of  loaning  money  to  the 
concern  will  resent  any  attempt  on  the  part  of  a  bor- 
rower to  anticipate  his  profits,  and  to  inflate  the  bor- 
rowing value  of  his  assets. 

It  is  often  suggested  that  the  element  of  interest, 
included  in  the  inventory,  be  deducted  on  the  balance 
sheet  by  the  creation  of  a  suitable  reserve  to  take  care 
of  the  overvaluation.  This  position  in  itself,  it  would 
seem,  ought  to  make  clear  the  fallacy  of  the  entire 
theory.  Books  of  account  exist  for  the  purpose  of 
recording  what  has  actually  taken  place,  and  not  what 
might  have  taken  place  under  a  set  of  hypothetical 
circumstances. 

13.  Cost  and  income  confused. — Another  objec- 
tion to  the  proposal  is  that  the  charge  for  interest  to 
cost  of  production,  and  a  corresponding  credit  to  an 

XXII— 17 


236     FINANCIAL  AND  BUSINESS  STATEMENTS 

earning  account,  has  the  effect  of  counting  the  same 
thing  both  as  cost  and  as  income.  A  consideration  of 
the  principles  of  economics  will  serve  to  clear  up  the 
erroneous  reasoning  indulged  in  by  those  who  favor 
this  method.  There  are  four  sources  of  wealth,  viz., 
land,  labor,  capital  variously  employed,  and  business 
organization.  The  income  derived  from  the  four 
sources  is  known  as  rent,  wages,  interest  and  profit. 
The  same  capital  cannot  be  employed  to  earn  two 
kinds  of  income,  that  is,  capital  invested  by  the  man- 
agers of  a  business  enterprise  cannot  simultaneously 
earn  both  interest  and  profit.  Clear  reasoning  be- 
comes possible  as  soon  as  we  come  back  to  the  funda- 
mental principles  of  economics. 

The  charge  for  interest  on  invested  capital  as  a 
part  of  the  cost  of  production  should  not  be  confused 
with  the  charge  for  interest  on  capital  which  would  be 
made  in  a  partnership  relation.  In  the  latter  in- 
stance it  is  made  for  the  purpose  of  adjusting  the 
inequities  of  capital  contributed  by  the  various  part- 
ners and  not  included  as  a  part  of  the  cost. 

REVIEW 

Why  is  the  ratio  of  net  income  to  capital  stock  an  inadequate 
test  of  the  profitableness  of  an  enterprise?  What  better  test 
could  you  propose? 

Who  are  the  persons  who  contribute  the  capital  to  an  enter- 
prise, and  what  are  their  respective  interests? 

State  the  arguments  against  the  point  of  view  that  the  interest 
upon  invested  capital  should  be  deemed  a  part  of  the  cost  of 
production. 


CHAPTER  XVIII 

CONSOLIDATED  BALANCE  SHEETS 

1.  Reasons  for  consolidations. — From  the  Texts 
on  "Organization  and  Control"  and  "Corporation 
Finance"  the  reader  has  noticed  the  important  reasons 
for  mergers,  consolidations  and  amalgamations.  The 
principal  advantages  claimed  for  these  types  of  or- 
ganization are:  reduction  of  managerial  expenses; 
elimination  or  reduction  of  ruinous  competition;  ad- 
vantageous terms  of  financing. 

According  to  the  advantages  gained  the  type  of 
organization  will  be  of  one  form  or  another. 

The  holding  company,  as  already  explained,  was 
organized  for  the  purpose  of  acquiring  the  stocks  or 
other  securities  of  affiliated  companies,  thus  effecting 
a  combination  which  would  bear  the  test  of  legal 
scrutiny.  The  earlier  pools  and  so  called  trusts  did 
not  accomplish  this  result  to  the  satisfaction  of  big 
industrial  enterprises. 

Under  the  newer  form  of  consolidation  each  com- 
pany not  only  retained  its  corporate  entity,  but  also 
in  the  eyes  of  the  law,  remained  a  separate  corpora- 
tion. Nevertheless,  the  virtual  consolidation  of 
ownership  was  beyond  question.  Such  being  the 
case,  the  results  of  this  ownership  can  only  be  prop- 

237 


238     FINANCIAL  AND  BUSINESS  STATEMENTS 

erly  expressed  in  a  statement  of  their  accounts  by 
consolidating  the  balance  sheets  of  the  "unit"  com- 
panies into  one  balance  sheet.  If  that  is  not  done  the 
balance  sheet  of  the  holding  company  would  not 
furnish  the  owners  of  the  corporation  with  the  in- 
formation about  its  financial  position  to  which  they 
are  justly  entitled. 

A  consolidated  balance  sheet,  therefore,  is  intended 
to  reveal  the  financial  position  of  the  whole  group  of 
affiliated  companies,  considered  as  one  enterprise. 

2.  Possible  legal  basis  for  consolidated  statements. 
— In  discussing  the  consolidated  income  account,  at- 
tention was  called  to  the  fact  that  there  was  no  legal 
basis  for  the  preparation  of  such  a  statement,  unless 
it  is  the  theory  of  a  true  valuation  of  assets.  It  is 
evident  that  changes  in  the  conditions  of  the  assets 
and  liabilities  of  a  holding  company  are  due  in  part, 
at  least,  to  the  results  of  operations  of  the  subsidiaries. 
The  increase  in  the  surplus  accounts  of  subsidiaries, 
unreduced  by  dividends,  enhances  the  value  of  the 
stock  which  the  holding  company  owns. 

While  it  is  not  a  desirable  practice  to  write  up  all 
assets  simply  because  they  have  appreciated  in  value, 
yet  it  is  a  common  practice  to  reflect  in  financial  state- 
ments all  changes  that  have  resulted  directly  from 
trading  operations.  On  the  theory,  therefore,  that 
the  financial  statements  of  a  holding  company  should 
reflect  such  increases  in  value  of  its  investments,  we 
may  eventually  require  by  law,  consolidated  state- 
ments which  will  show  the  exact  condition  of  affairs 


CONSOLIDATED  BALANCE  SHEETS         239 

for  the  group  as  a  whole.  Appreciations  in  value 
other  than  those  resulting  from  trading  or  manufac- 
turing operations  would,  of  course,  be  omitted. 

3.  Investments  carrying  less  than  control. — As  a 
stockholder,  the  investing  corporation  has  an  undi- 
vided interest  in  the  assets  of  the  sub-companies  to 
the  extent  of  its  holdings  of  stock,  and  it  is  desirable 
to  show  the  value  of  this  investment  at  its  actual 
worth  instead  of  at  its  cost  to  the  purchasing  com- 
pany. We  have  our  choice  of  recording  such  invest- 
ments, by  either  of  the  following  methods. 

4.  Carrying  at  cost. — The  first  method  is  that  of 
carrying  the  investment  at  its  original  cost  to  the  pur- 
chaser. This  plan  has  much  to  commend  it  from  the 
conservative  standpoint.  This  is  especially  true,  if 
care  is  taken  to  write  down  the  asset  when  its  value 
has  depreciated.  The  main  objection  to  such  a  pro- 
cedure, however,  is  that  cost  and  value  do  not  remain 
constant  for  any  length  of  time. 

5.  Periodic  revaluation. — This  brings  us  to  the 
question  of  whether  or  not  a  periodic  revaluation  of 
the  investment  is  possible.  While  this  might  be  the 
most  satisfactory  solution  under  theoretical  condi- 
tions, it  will  not  be  found  to  work  out  satisfactorily 
in  practice,  because  accuracy  in  the  revalution  is  im- 
possible. There  is  no  true  basis  on  which  a  revalua- 
tion can  be  made  other  than  the  actual  physical 
inventory  or  market  price  of  the  stock.  The  market 
price  is  dependent  upon  many  outside  factors,  while 
the  actual  revaluation  is  sometimes  physically  impos- 


240     FINANCIAL  AND  BUSINESS  STATEMENTS 

sible.  At  best,  actual  revaluation  would  simply  be 
the  opinion  of  men  who  might  or  might  not  be  qual- 
ified to  make  the  revaluation. 

6.  The  equity  in  surplus, — It  is  sometimes  cus- 
tomary to  carry  the  increase  in  surplus  directly  into 
the  investing  company's  surplus  account,  rather  than 
to  set  it  up  under  a  separate  heading.  In  such  a 
case,  dividends  declared  from  the  combined  surplus 
should  be  based  upon  the  amount  of  current  receiv- 
ables included  in  the  current  assets  of  the  sub-com- 
pany. The  practice  is  not  to  be  recommended,  how- 
ever, unless  the  investing  company  is  certain  that  it 
will  soon  realize  on  a  portion  of  its  share  of  the  other 
company's  surplus.  While  the  investing  company  has 
set  up  in  its  balance  sheet  a  current  asset  representing 
its  interest  in  the  other  company,  there  is  ordinarily  no 
positive  means  of  telling  whether  this  current  asset 
will  be  realized  upon. 

A  dangerous  situation  may  result  from  this  prac- 
tice, if  dividends  have  been  paid  by  the  investing  com- 
pany out  of  its  equity  in  the  net  assets  or  surplus  of 
the  other  corporation.  If  some  catastrophe  over- 
takes the  sub-company  and  wipes  out  this  surplus, 
the  directors  of  the  investing  company  would  prob- 
ably be  found  guilty  of  paying  dividends  out  of  cap- 
ital. Therefore,  great  discretion  must  be  exercised 
by  directors  in  handling  these  accounts  after  they 
have  been  set  up  on  the  books. 

7.  Treatment  of  dividends. — Dividends  received 
on  such  an  investment  should  be  credited  to  the  in- 


CONSOLIDATED  BALANCE  SHEETS         241 

vestment  instead  of  being  treated  as  current  earnings. 
This  statement  hardly  requires  an  explanation  because 
it  is  evident  that  we  have  already  taken  credit  for  the 
earnings  when  the  asset  was  appreciated  and  the  sur- 
plus account  set  up. 

If  a  separate  surplus  account  is  carried,  then  the 
amount  of  the  dividends  received  must  be  also  trans- 
ferred from  this  special  surplus  account  to  the  free 
surplus  of  the  receiving  company. 

8.  Objection  to  carrying  the  investment  at  cost. — 
It  is  also  evident  that  the  practice  of  carrying  the  in- 
vestment previously  described,  at  cost  in  the  books 
of  the  holding  company  has  another  disadvantage. 
The  balance  sheet  of  the  holding  company  will,  of 
course,  disclose  howl  much  of  its  capital  has  been  in- 
vested in  this  sub-company.  But  the  earning  account 
of  the  holding  company  may  not  disclose  the  entire 
earnings  of  that  capital.  Thus,  if  the  sub-company 
did  not  distribute  any  of  its  accumulated  surplus  in 
the  form  of  dividends,  failure  to  record  the  effect  of 
this  appreciation  in  the  value  of  the  sub-company's 
stock,  due  to  the  increased  surplus,  would  also  result 
in  an  understatement  of  the  true  earnings  of  the 
holding  company. 

9.  Revaluation  of  investments  is  subject  to  com- 
plications.— When  a  holding  company  has  paid  for 
stock  of  subsidiaries  considerably  more  than  the  book 
value,  complications  often  arise.  Moreover,  the 
stock  or  the  bonds  of  the  holding  company  may  have 
been  issued  in  payment  for  the  securities  of  the  sub- 


242     FINANCIAL  AND  BUSINESS  STATEMENTS 

sidiary  company  which  is  acquired.  The  question 
then  raised  would  be  whether  or  not  the  directors  in 
reappraising  the  value  of  the  securities  originally 
acquired,  perhaps  at  a  liberal  price,  should  add 
to  the  cost  thereof  by  means  of  an  equity  account, 
the  pro-rata  share  of  the  undistributed  earnings  of  the 
subsidiary,  subsequent  to  the  date  of  the  acquirement 
of  the  securities  by  the  holding  company.  While  the 
valuation  placed  upon  the  stock  of  the  sub-company 
acquired  originally  by  the  directors  would  probably 
never  be  questioned,  the  directors  might  have  diffi- 
culty in  proving  that  they  were  justified  in  creating  a 
surplus,  and  in  distributing  a  dividend  out  of  it,  when 
such  surplus  was  created  thru  their  own  reappraisal 
of  the  securities. 

10.  Oppressive  tactics  to  discourage  minority  in- 
terests,— It  very  often  happens  that  the  sub-company 
has  received  large  cash  advances  from  the  holding 
company.  The  subsidiary  company,  having  increased 
its  earnings  and  its  surplus,  would  probably  be  in  a 
position  to  distribute  a  reasonable  dividend.  Assum- 
ing that  the  holding  company  is  desirous  of  practising 
oppressive  tactics  to  the  disadvantage  of  minority 
stockholders  and  suddenly  withdraws  its  advances 
from  the  sub-company  it  thereby  reduces  the  sub-com- 
pany's cash  and  working  capital  and  effectually  pre- 
vents it  from  declaring  a  dividend,  even  tho  it  has 
earned  profits.  The  holding  company,  in  recovering 
its  cash,  has  practically  enjoyed  the  receipt  of  a  divi- 


CONSOLIDATED  BALANCE  SHEETS         243 

dend.     This  form  of  oppression  has  often  been  em- 
ployed. 

As  already  pointed  out,  the  failure  to  incorporate 
in  the  accounts  of  the  holding  company  the  presence 
of  this  surplus  results  in  the  creation  of  a  secret  re- 
serve. This  is  an  additional  disadvantage  to  that  re- 
sulting from  the  fact  that  equalization  of  the  income 
of  the  holding  company  from  one  period  to  another  is 
not  provided  for  by  this  method. 

It  is  obvious  that  an  equitable  method  of  prepar- 
ing consolidated  statements  should  be  employed. 
The  main  thing  to  bear  in  mind  here  is  the  elimination 
of  all  inter-company  transactions  by  the  offsetting  of 
the  debit  items  of  one  company  by  the  corresponding 
credit  items  of  an  affiliated  company.  This  applies, 
of  course,  only  to  such  items  as  represent  actual  trans- 
actions or  relations  between  the  associated  com- 
panies. 

11.  Illustration. — On  pages  247  and  248  will  be 
found  an  example  of  the  method  of  preparing  a  com- 
paratively simple  consolidated  balance  sheet.  Con- 
sidering the  items  on  this  statement  in  detail,  it  will  be 
noted  that  the  "A"  company  held  $81,000  in  bonds  is- 
sued by  the  "B"  Company,  and  that  "C"  Company 
held  $119,000  of  the  same  bonds.  As  the  liability  of 
the  "B"  Company  is  offset  by  an  asset  of  the  same 
item  on  the  books  of  "A"  and  "B"  Companies,  the 
consolidated  balance  sheet  need  not  show  either  the  as- 
set   or    the    liability.     Consequently,    we    eliminate 


244     FINANCIAL  AND  BUSINESS  STATEMENTS 

$200,000  from  our  total  assets  and  $200,000  from  our 
total  liabilities.  In  this  same  way,  the  advances  to 
and  from  affiliated  companies,  dividends  receivable  or 
payable  between  the  affiliated  companies,  and  accrued 
interest  on  the  bonds,  together  with  demand  notes,  are 
set  against  the  corresponding  accounts  of  affiliated 
companies.  A  statement  results  which  shows  only  the 
relation  of  the  combined  group  to  its  stockholders  and 
to  the  public. 

If  the  "B"  Company,  for  example,  was  in  poor 
financial  condition,  or  had  suffered  heavy  losses  from 
operation  during  the  year,  this  condition  would  be  re- 
flected in  the  combined  balance  sheet  in  so  far  as  it 
affected  the  standing  of  the  group  and  that,  after  all, 
is  the  information  which  an  investor  or  stockholder 
wishes  to  have. 

THE  "A"  COMPANY 

Balance  Sheet  as  at 191 . . 

Fixed  Assets 

Land  and  Buildings  $294,000 

Machinery  and  Equipment 178,600 

Investment  in  Bonds  of  Company  "B" 81,000 

Outside  Stock  Investments 200,000    §    753.600.00 

Working  and  Trading  Assets 

Materials  and  Supplies  $  46,140 

Goods  in  Process   48,274 

Finished  Goods    60,800         155,214.00 

Current  Assets 

Cash $  73,510 

Accounts  Receivable 47,100 

Demand  Notes  Company  "B" 45,000 

Accrued  Interest  Receivable   1,032.75     166,642.75 

Total    Assets $1^075,456.75 


CONSOLIDATED  BALANCE  SHEETS         245 

Capital  Liabilities 
Common  Capital  Stock  Issued  and  Outstanding 

(Authorized  $1,000,000)    $600,000 

Preferred  Capital  Stock  Issued  and  Outstanding 

(Authorized    $1,000,000)     100,000    $    700,000.00 

Current  Liabilities 

Loans    Payable    $  36,000 

Advances  by  Company  "C" 60,000 

Vouchers  and  Accounts  Payable  58,120 

Dividends  Payable   100,000         254,120.00 

Reserves 

For  Depreciation    §  34,900 

For  Doubtful  Accounts   Receivable    5,000 

For    Contingencies     36,000  75,900.00 

Profit  and  Loss  Surplus  45,436.75 

Total  Capital,  Liabilities,   Reserves   and  Sur- 
plus   $1,075,456.75 


THE  "B"  COMPANY 

Balance  Sheet  as  at 191 .  . 

Fixed  Assets 

Land  and  Buildings   $495,000.00 

Machinerv  and  Equipment    594,800.00 

Outside  Stock  Investments 150,000.00    $1,239,800.00 

Working  and  Trading  Assets 

Materials  and  Supplies $  56,250.00 

Goods  in  Process 50,600.00 

Finished   Goods    75,460.00         182,310.00 


Current  Assets 

Cash    $122,564.76 

Accounts  Receivable   92,460.00         215,024.76 


Total  Assets $1,637,134.76 


Capital  Liabilities 

Common    Capital    Stock    Issued    and    Out- 
standing  (Authorized  $1,000,000) $1,000,000.00 

First  Mortgage  Bonds  6%,  1925— J.  &  J.  . .      300,000.00 


$1,300,000.00 


246     FINANCIAL  AND  BUSINESS  STATEMENTS 

Current  Liabilities 

Demand   Notes   Payable $  45,000.00 

Loans    Payable    . .  I 50,000.00 

Advanced  'by  Company  "C" 60,000.00 

Vouchers  and  Accounts  Payable    28,865.00 

Dividends  Payable    25,000.00 

Accrued  Interest  on  Bond 3,825.00         212,690.00 

Reserves 

For  Depreciation    $      60,500.00 

For  Doubtful  Accounts 4,500.00  65,000.00 

Profit  and  Loss  Surplus 59,444.76 

Total    Capital,    Liabilities,    Reserves    and 

Surplus     $1,637,134.76 


THE  "C"  COMPANY 

Balance  Sheet  as  at 191 .  . 

Fixed  Assets 

Stock  Investments    §2,217,600.00 

10,000   Shares   Common   Stock   "B"   Co. 
6,000   Shares   Common   Stock  "A"   Co. 
1,000  Shares  Preferred  Stock  "A"  Co. 
Bonds  of  "B"  Company  6%,  1925  J.  &  J.  . .      119,000.00    $2,336,600.00 

Current  Assets 

Cash    $  941,882.75 

Advances  to  Subsidiaries 120,000.00 

Dividends  Receivable  125,000.00 

Accrued  Interest  Receivable 1,517.25       1,188,400.00 

Total   Assets    $3,525,000.00 

Capital  Liabilities 

Common  Capital  Stock  Issued  and  Outstand- 
ing   (Authorized  $3,000,000) $2,000,000.00 

Preferred    Capital    Stock    Issued    and    Out- 
standing  (Authorized  $2,000,000) 1,400,000.00    $3,400,000.00 

Profit  and  Loss  Surplus 125,000.00 

Total  Capital  and  Surplus $3,525,000.00 


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248 


CONSOLIDATED  BALANCE  SHEETS         249 


REVIEW 

What  different  methods  may  the  holding  company  pursue  in 
valuing  stock  held  in  subsidiaries? 

Under  what  conditions  should  dividends  on  the  stock  of  sub- 
sidiaries not  be  credited  to  income  of  parent  company? 

How  can  a  holding  company  pursue  oppressive  tactics  to  dis- 
courage minority  interests? 


CHAPTER  XIX 

CONSOLIDATED  BALANCE  SHEETS   (Continued) 

1.  Premium  on  Investments, — The  amount  paid 
for  stock  purchased,  presumably  represents  the  intrin- 
sic value  of  that  stock  to  the  purchaser;  unless  the 
stock  was  taken  over  at  its  par  value  at  the  time 
that  the  concern  was  organized,  it  is  unlikely  that  it 
would  be  subsequently  acquired  at  that  valuation. 
As  already  illustrated,  the  par  value  of  the  stock  can 
be  eliminated  from  both  sides  of  the  consolidated  bal- 
ance sheet  by  taking  the  par  value  as  shown  by  the 
books  of  the  issuing  company  and  eliminating  that 
amount  from  the  assets  held  by  the  purchasing  com- 
pany, and  from  the  combined  capital  stock  outstand- 
ing. 

The  excess  above  par,  paid  by  the  purchasing  com- 
pany is  nothing  more  than  the  amount  paid  by  it  for 
the  good-will  and  accumulated  surplus  of  the  issuing 
company.  It  is  customary  to  carry  this  item  under  a 
separate  heading  termed  "Good- will"  or,  better 
"Premiums  on  Investments  in  Affiliated  Companies.' 
The  asset  then  stands  on  the  books  at  its  net  cost  and 
under  a  heading  which  clearly  denotes  its  peculiar  na- 
ture. In  the  example  on  pages  247  and  248,  the 
reader  will  have  noted  that  while  the  "C"  Company 

250 


;. 


CONSOLIDATED  BALANCE  SHEETS         251 

carried  stocks  on  its  books  at  a  valuation  of  $2,217,- 
600.00,  this  item  was  offset  by  a  credit  on  the  books  of 
the  subsidiary  companies  amounting  to  only  $1,- 
700,000.00.  The  difference  of  $517,600.00  can  be 
treated  upon  the  consolidated  balance  sheet  as  good- 
will. Premiums  paid  for  bonds  (in  affiliated  com- 
panies only)  would  be  handled  in  the  same  manner. 
The  same  method  is  applied  to  stocks  and  bonds  of  a 
subsidiary  company,  acquired  by  another  subsidiary. 

2.  Other  methods  of  carrying  premium  on  invest- 
ments. — The  management  might  not  desire  to  carry 
this  intangible  asset  in  the  consolidated  balance  sheet. 
In  this  event  it  would  be  entirely  legitimate  to  offset 
this  item  of  premium  on  investments  against  the  com- 
bined surplus.  For  instance,  as  has  already  been  in- 
dicated, the  net  worth  of  a  corporation  is  its  capital 
and  surplus.  If  the  entire  stock  of  that  corporation 
is  purchased  at  its  book  valuation,  the  premium  paid 
for  the  stock  purchased  equals  in  effect,  exactly  the 
amount  of  its  surplus  at  the  time  of  the  purchase.  In 
the  consolidated  balance  sheet,  the  items  of  premium 
and  purchased  surplus  exactly  offset  each  other. 
However,  this  ideal  situation  does  not  often  occur. 
Purchases  of  securities,  especially  if  they  are  paid  for 
in  the  stock  of  the  purchasing  corporation,  are  nearly 
always  bought  on  a  very  liberal  basis.  Something  is 
paid  for  the  intangible  asset,  good-will  of  the  selling 
company,  in  addition  to  the  book  value  of  the  net 
assets. 

If,  under  these  circumstances,  we  attempted  to 

XXII— 18 


252     FINANCIAL  AND  BUSINESS  STATEMENTS 

offset  the  premium  against  the  combined  surplus, 
we  would  wipe  out  the  entire  surplus  of  the  sub- 
sidiary company  and  still  not  dispose  of  the  amount 
paid  for  the  good-will.  This  method  is,  however,  sel- 
dom resorted  to. 

The  item,  good-will,  included  in  the  consolidated 
balance  sheet  will,  therefore,  represent  not  only  the 
good-will  shown  on  the  books  of  the  subsidiary  com- 
pany, but  in  addition,  the  amount  paid  by  the  holding 
company,  either  in  cash  or  in  securities,  for  the  good- 
will of  the  selling  company,  represented  by  the  differ- 
ence between  the  cash  or  par  value  of  the  securities 
paid  and  the  book  value  of  the  securities  received  in 
exchange. 

3.  Discounts  on  investments. — A  similar  situation 
but  with  opposite  results,  exists  when  the  stock 
of  an  affiliated  company  is  purchased  at  a  discount. 
A  special  surplus  results  equal  to  the  amount  of  this 
discount.  It  is  seldom  either  proper  or  desirable, 
however,  to  carry  this  item  in  the  surplus  account  as 
free  surplus.  It  is  considered  better  to  offset  the 
amount  of  such  a  surplus  against  the  good-will  asset 
appearing  in  the  consolidated  balance  sheet. 

If  there  were  several  corporations  involved  in  the 
consolidation,  and  some  stock  is  purchased  at  a  pre- 
mium and  some  at  a  discount,  it  is  better  to  set  the  dis- 
count against  the  premium,  carrying  only  the  net 
premium  paid  into  the  consolidated  balance  sheet. 
If  the  stock  of  one  of  the  subsidiaries  has  been  pur- 
chased at  a  discount,  it  is  evident  that  this  particular 


CONSOLIDATED  BALANCE  SHEETS         253 

company  was  not  in  so  prosperous  a  condition  as  the 
others.  When  the  consolidation  took  place,  the  dif- 
ferent companies  became,  in  effect,  one  organization 
and  the  value  of  one  is  affected  by  the  value  of  the 
other.  Therefore,  the  good-will  of  the  combined  or- 
ganization is  diminished  by  the  amount  of  the  depre- 
ciated value  of  the  less  prosperous  corporation. 

If,  however,  this  stock  was  purchased  at  a  discount 
as  a  result  of  outside  factors  and  its  actual  value  was 
par  or  higher,  then  the  increment  undoubtedly  belongs 
in  the  surplus  account.  As  a  rule,  this  surplus  result- 
ing from  stock  purchased  at  a  discount  would  have  to 
be  applied  against  the  deficit  in  the  account  of  the  sub- 
sidiary, if  a  deficit  exists,  which  is  quite  probable,  or 
the  purchase  of  the  stock  could  not  have  been  made  at 
a  discount.  If  a  deficit  does  not  exist,  then  it  is  im- 
portant to  be  sure  that  some  of  the  assets  have  not 
been  over-valued  thru  failure  to  make  adequate  pro- 
vision for  depreciation. 

4.  Treatment  of  deficits  existing  in  sub-companies. 
— In  cases  where  a  holding  company  purchases  stock 
of  a  company  whose  balance  sheet  shows  a  deficit  from 
operation,  the  value  of  the  capital  stock  of  the  sub- 
sidiary company  would  probably  be  reduced  to  make 
up  for  the  deficit.  While  the  deficit  is,  in  effect,  ab- 
sorbed at  the  time  of  the  purchase,  any  subsequent 
dividends  by  that  corporation  cannot  legally  be  dis- 
tributed as  dividends  until  the  deficit  has  been  made 
up.  Therefore,  while  in  the  consolidated  balance 
sheet  the  entire  group  must  make  up  for  the  deficit 


254     FINANCIAL  AND  BUSINESS  STATEMENTS 

of  one  company,  the  law  will  not  permit  the  subsidiary- 
company  to  pay  dividends  until  it  has  made  up  its 
own  deficit. 

5.  Protection  of  minority  interests, — Where  a 
minority  stock  interest  exists,  the  minority  stockhold- 
ers have  a  right  to  their  share  of  the  profits  made 
on  inter-company  transactions.  Consequently,  it  is 
legitimate  and  necessary  for  the  consolidated  state- 
ments to  show  as  an  asset  the  proportion  of  inter-com- 
pany profits  on  construction,  prepaid  expenses,  in- 
ventories, and  the  like,  which  will  accrue  to  the  minor- 
ity stockholders  of  the  subsidiary  company.  The 
proportion  of  the  surplus  of  the  subsidiary  company 
belonging  to  the  minority  stockholders  may  be  set  up 
in  the  balance  sheet  under  a  special  heading,  "Equity 
of  Minority  Stockholders  of Company." 

6.  Capitalized  surplus. — In  dealing  with  the  ques- 
tion of  surplus,  it  was  pointed  out  that  if  dividends 
can  be  paid  out  of  the  surplus  of  a  subsidiary  com- 
pany without  reducing  the  surplus  below  the  amount 
that  existed  at  the  time  of  consolidation,  such  divi- 
dends constitute  income  to  the  holding  company. 
Also,  when  the  dividend  reduces  the  amount  of  the 
capitalized  surplus,  the  reduction  is  treated  as  a  re- 
turn of  the  investment  on  the  books  of  the  holding 
company.  The  capitalized  surplus  then  becomes  a 
new  figure,  changed  by  the  amount  of  its  reduction, 
and  should  be  considered  as  a  new  amount  in  all  sub- 
sequent statements  or  calculations. 

From  this,  it  is  apparent  that  a  holding  company 


CONSOLIDATED  BALANCE  SHEETS         255 

may  have  four  kinds  of  surplus:  free,  capitalized, 
minority  equity  and  appropriated. 

7.  Method  of  treating  surplus  accounts  of  ac- 
quired companies. — The  above  topics  very  naturally 
bring  up  the  question  of  recording  these  transactions. 
No  difficulty  arises  when  all  the  stock  of  the  subsidiary 
is  owned  by  the  holding  company,  and  when  the  direc- 
tors of  the  holding  company  are  also  the  directors  of 
the  subsidiary  company,  or  at  least  control  the  board. 
They  may  direct  that  the  surplus  of  the  subsidiary 
company  at  the  date  of  the  purchase  be  set  aside,  and 
appropriately  designated  on  its  own  books.  The  title 
of  the  account  will  then  tell  exactly  the  nature  of  its 
contents. 

When  purchases  of  the  stock  of  the  subsidiary  are, 
however,  made  at  various  times,  it  is  seldom  possible 
to  set  aside  each  portion  of  the  capitalized  surplus  on 
the  books  of  the  subsidiary  company,  because  the  con- 
trol of  the  sub-company  may  not  be  obtained  imme- 
diately. Again,  the  rights  of  the  minority  stockhold- 
ers enter  and  prohibit  the  splitting  of  the  surplus  ac- 
count under  such  conditions.  But,  in  the  consoli- 
dated statement,  it  will  be  necessary  in  every  case  to 
indicate  the  various  additions  to  the  capitalized  sur- 
plus. Each  new  purchase  of  stock  by  the  holding 
company  carries  with  it  a  proportion  of  the  surplus 
existing  at  the  date  the  purchase  price  was  agreed 
upon,  thus  increasing  the  item  of  capitalized  surplus 
of  the  consolidated  company. 

8.  Other  phases  of  capitalized  surplus. — The  same 


256     FINANCIAL  AND  BUSINESS  STATEMENTS 

principle  of  indicating  additions  to  the  capitalized  sur- 
plus holds  good,  even  tho  the  purchase  was  not  based 
directly  upon  the  book  value  of  the  stock  of  the  sub- 
sidiary company.  The  holding  company  capitalizes 
the  condition  of  the  subsidiary  at  the  time  it  makes 
the  purchases.  Dividends  out  of  the  surplus  existing 
at  the  time  of  the  purchase  are  nothing  more  than  a 
partial  liquidation  of  its  investment.  It  should  be 
noted  also  that  the  date  of  purchase  means  either  the 
date  at  which  the  purchase  price  was  agreed  upon, 
or  the  date  of  the  financial  condition  forming  the  basis 
of  the  purchase  price.  Earnings  subsequent  to  that 
date,  even  tho  the  entire  sales  contract  in  reference  to 
stock  has  not  been  completed,  may  properly  be  treated 
as  income  accruing  to  the  holding  company  when  such 
earnings  are  paid  to  it  in  the  form  of  dividends. 

No  great  difficulty  has  been  confronted  thus  far, 
but  it  is  not  so  simple  to  handle  such  transactions 
when  the  stock  is  not  purchased  at  one  time,  and  when 
control  is  secured  by  various  purchases  made  at  dif- 
ferent times.  The  basis  for  these  purchases  may  be 
the  stock  market  valuation  of  the  stock  in  question. 
However,  the  same  principles  are  involved,  and  the 
portion  of  the  surplus  accruing  to  each  separate  pur- 
chase becomes  an  asset  of  the  holding  company  and 
must  be  capitalized  on  its  books,  and  in  the  consoli- 
dated statement.  Any  dividends  received  out  of 
these  separate  items  of  capitalized  surplus  become  a 
return  or  liquidation  of  the  investment. 

When  the  relation  between  the  amounts  of  "capital- 


CONSOLIDATED  BALANCE  SHEETS         257 

ized  surplus"  and  the  corresponding  asset  of  "pre- 
mium on  investments  of  subsidiaries"  is  favorable,  it 
is  advisable  to  set  the  capitalized  surplus  aside  under 
a  separate  heading.  More  frequently,  it  must  be  ad- 
mitted, the  premium  is  far  in  excess  of  the  surplus  at 
the  time  of  purchase.  The  better  showing  will  then 
be  made  if  only  one  surplus  account  is  carried. 

When  stock  in  a  subsidiary  company  is  purchased, 
the  surplus  of  that  company  as  of  the  date  of  pur- 
chase becomes  capitalized  by  this  purchase.  Any  div- 
idends declared  and  paid  by  the  subsidiary  company 
out  of  this  surplus  may  not  be  treated  as  income  to 
the  holding  company,  but  rather  as  a  reduction  in  the 
value  of  the  assets^  and  must  be  treated  accordingly. 
Perhaps  this  statement  can  be  made  clearer  if  we  con- 
sider the  theoretical  situation  of  a  holding  company 
purchasing  stock  in  a  subsidiary  company  by  giving 
its  own  stock  in  exchange.  The  exchange  is  made 
upon  the  basis  of  the  par  value  of  the  stock  and  the 
surplus  of  the  subsidiary  company  as  of  the  date  of 
purchase.  This  results  in  the  surplus  of  the  sub- 
sidiary company  being  capitalized  on  the  books  of 
the  holding  company. 

9.  Illustration  of  capitalized  surplus. — The  stock 
and  surplus  of  the  subsidiary  company  measure  the 
net  assets  of  that  company.  The  holding  company 
purchases  the  stock  at  book  value  issuing  its  own  stock 
at  par  in  payment.  If  the  subsidiary  company  de- 
clares a  dividend  out  of  the  surplus  capitalized,  the 
payment  of  this  dividend  decreases  the  amount  of  its 


258     FINANCIAL  AND  BUSINESS  STATEMENTS 

net  assets,  and  in  turn  decreases  the  equity  of  the  hold- 
ing company  in  those  net  assets.  Therefore,  such 
dividends  received  by  the  holding  company,  constitute 
a  decrease  in  the  value  of  its  investment  in  the  sub- 
sidiary, and  are  not  income  in  any  sense  of  the  word. 
They  should  be  credited  to  the  investment  account  on 
the  books  of  the  holding  company. 

10.  Unpaid  cumulative  dividends  of  subsidiaries. 
— In  preparing  the  balance  sheet  of  a  holding  com- 
pany, there  are  several  items  which  will  require 
slightly  different  treatment  from  that  ordinarily  ac- 
corded to  them.  Thus,  it  is  customary  to  show  as  a 
direct  liability  of  a  business  organization,  the  liability 
for  unpaid  cumulative  dividends.  As  dividends  are 
not  a  liability  until  they  have  been  declared  by  the 
board  of  directors,  a  corporation  that  has  unpaid  cu- 
mulative preferred  stock  dividends,  need  not  show 
such  liability  directly,  except  as  a  footnote  in  the  bal- 
ance sheet.  Cumulative  unpaid  preferred  stock  divi- 
dends of  subsidiaries  should  be  similarly  shown  in  a 
consolidated  balance  sheet. 

11.  When  control  is  not  complete. — If  «the  hold- 
ing company,  or  its  subsidiary,  purchases  material 
from  an  affiliated  company  in  which  the  stock  control 
is  not  complete,  the  usual  procedure  is  varied  slightly. 
More  extensive  records  are  necessary  to  protect  the 
rights  of  the  minority  stockholders  in  the  vending  cor- 
poration. Consequently,  the  initial  transaction  is  car- 
ried on  at  cost,  plus  the  customary  profit.  On  the 
books  of  the  purchasing  company,  the  proportion  of 


CONSOLIDATED  BALANCE  SHEETS         259 

inter-company  profit  is  charged  back  from  the  asset  or 
purchasing  account  to  a  separate  account,  in  which  it 
is  considered  as  a  charge  against  any  dividend  from 
such  earnings  that  may  be  received  from  the  vendor 
subsidiary.  All  dividends  received  out  of  inter- 
company profits  must  be  credited  to  this  charge. 
These  charges  and  credits  must  pass  thru  the  books  of 
the  holding  company.  All  companies  which  are  as- 
sociated must  have  the  same  accounting  system, 
the  same  accounts,  and  a  common  fiscal  year.  As  was 
previously  indicated,  the  inter-company  profits  may 
only  be  eliminated  from  the  surplus  and  asset  accounts 
in  the  balance  sheet. 

In  any  event,  however,  the  books  of  each  company 
must  be  sufficiently  detailed  to  show  cost  and  profit  on 
each  sale.  This  information  must  be  passed  on  to  the 
purchaser  so  that  he  may  know  the  amount  of  inter- 
company profit  occurring  with  each  inter-company 
transaction.  These  purchases,  however,  will  be  taken 
on  the  books  at  full  cost,  including  the  vendor's  profit, 
if  any  is  charged.  All  inter-company  transactions 
must  be  recorded  separately  from  similar  transactions 
made  with  outsiders. 

While  consolidated  statements,  as  just  described, 
give  a  fair  and  equitable  picture  of  the  condition  of 
the  group  as  a  whole,  they  do  not  show  the  status  of 
the  individual  companies.  For  example,  the  classes 
of  obligations  are  not  shown  in  detail.  Many  addi- 
tional details  will  often  be  desired  by  the  manage- 
ment, stockholders,  investors  or  creditors  of  the  hold- 


260     FINANCIAL  AND  BUSINESS  STATEMENTS 

ing  company  or  its  subsidiaries.  In  fact,  the  consol- 
idated statement  is  open  to  the  same  objections  that 
apply  to  any  other  condensed  financial  statement. 

12.  Overcoming  disadvantages  of  consolidated 
statements. — The  disadvantages  of  consolidated  state- 
ments may  be  overcome  by  making  schedules  detail- 
ing the  kinds  of  assets  and  liabilities  a  part  of  the  con- 
solidated statement.  The  same  purpose  would  be  an- 
swered by  the  current  publication  of  the  detailed  state- 
ments of  each  subsidiary  company.  Or,  when  the 
number  of  companies  involved  is  not  too  great,  the 
consolidated  statement  itself  may  be  made  up  in  the 
form  of  the  working  sheet,  illustrated  on  pages  247 
and  248.  This  working  sheet  shows  the  detailed  ac- 
count of  each  subsidiary  company,  and  the  consolida- 
tion statement  for  all.  In  the  published  statements, 
the  column  headed  "Eliminations,"  would,  of  course, 
be  omitted. 

13.  Interpretation  of  consolidated  statements. — 
In  general,  the  interpretation  of  consolidated  state- 
ments is  subject  to  the  same  rules  as  the  interpreta- 
tion of  any  other  financial  statement  of  a  single  com- 
pany. There  are,  however,  several  points  peculiar 
to  this  type  of  statement,  which  require  special  men- 
tion. As  we  have  seen,  the  method  of  interpreting 
financial  statements  depends  upon  the  purpose  for 
which  the  information  is  to  be  used.  There  is  prob- 
ably no  better  way  of  discussing  the  points  of  par- 
ticular interest  in  reading  consolidated  statements 
than  to  approach  the  topic  from  the  three  angles  of 


CONSOLIDATED  BALANCE  SHEETS         261 

efficiency  of  operation  and  management,  credit  risk 
and  investment  standpoint. 

In  a  consideration  of  the  first  viewpoint,  it  is  appar- 
ent that  consolidated  statements  will  be  of  most  value 
if  used  in  conjunction  with  detailed  statements. 
Whoever  analyzes  the  statements  with  the  idea  of 
measuring  the  efficiency  of  operation  and  manage- 
ment will  be  interested  in  the  separate  results  of  in- 
dividual companies  and  departments,  as  well  as  in 
the  progress  of  the  company  as  a  whole. 

With  this  end  in  view  he  will  find  that  comparative 
consolidated  balance  sheets  and  income  statements 
will  show  the  changes  in  financial  condition  and  the 
increase  or  decrease  in  total  earnings.  The  details  of 
the  individual  company  statements  will  explain  the 
fluctuations  in  the  combined  statement.  If  the  hold- 
ing company  group  has  been  but  recently  organized, 
a  comparison  of  the  consolidated  income  statement 
with  a  consolidation  of  the  individual  income  state- 
ments, prior  to  combination,  will  show  at  a  glance 
whether  or  not  the  expected  economies  of  consolida- 
tion have  resulted. 

Also,  when  new  corporations  have  been  absorbed  in 
the  interim  between  statement  periods,  a  check  on  the 
wisdom  of  such  a  step  may  be  had  if  the  condition  and 
profits  of  that  company,  both  before  and  after  consol- 
idation, are  compared.  The  stockholder  will  use  this 
information  to  control  his  board  of  directors  and  to 
guide  him  at  the  annual  election. 

14.  Value  of  individual  statements  to  managing 


262     FINANCIAL  AND  BUSINESS  STATEMENTS 

officials. — An  executive  officer,  or  any  one  else, 
using  these  statements  as  a  guide  to  operation  and 
management,  would  first  examine  the  progress  of  the 
group  as  shown  by  the  comparative  consolidated  state- 
ment. Any  unusual  changes  would  be  traced  back 
to  their  sources  in  the  individual  company.  Finan- 
cial conditions  would  be  analyzed,  changes  investi- 
gated and  the  effect  of  past  policies  noted  with  a  view 
of  avoiding  what  was  unsatisfactory. 

15.  Credit  risk  viewpoint. — The  banker  or  trade 
creditor,  on  the  other  hand,  has  little  interest  in  the 
individual  statements.  He  would  use  them  only  in 
tracing  down  the  unfavorable  conditions  and  estimat- 
ing the  probable  future  effects  of  individual  com- 
panies on  the  group.  He  is,  however,  vitally  inter- 
ested in  the  efficiencv  of  the  management  and,  to  this 
extent,  he  must  estimate  how  much  the  future  finan- 
cial condition  will  be  improved  or  weakened  by  the  ac- 
tions of  the  management.  For  this  purpose,  he  must 
use  comparative  consolidated  statements  and  compara- 
tive individual  statements.  His  attention,  then,  is 
chiefly  devoted  to  the  present  relation  between  current 
receivables  and  current  payables,  and  the  expected 
changes  which  will  result  from  the  introduction  of  new 
factors  and  from  an  alteration  of  the  policies  of  the 
management.  He  looks  at  the  statement,  however, 
solely  to  determine  group  conditions. 

16.  Investment  standpoint. — The  investor's  pur- 
pose in  examining  the  statements  of  a  holding  com- 
pany, is  first  to  determine  the  security  of  his  invest- 


CONSOLIDATED  BALANCE  SHEETS    263 

ment.  It  must  be  assumed  that  all  investments  are  to  be 
made  in  the  stocks  and  bonds  of  the  holding  company. 
If  investment  in  a  subsidiary  were  to  be  considered, 
the  subsidiary's  condition  must  be  viewed  in  the  light 
of  its  relations  to  the  group.  A  minority  investment 
under  such  conditions  is  to  be  avoided,  as  a  stockholder 
has  no  certainty  that  the  holding  company  will  not 
manipulate  the  subsidiary  for  its  own  individual  gain. 

An  investor  in  a  holding  company  will  also  verify 
the  valuation  of  the  fixed  assets.  As  the  valuation  of 
good-will  is  dependent  in  part  upon  the  economics  of 
consolidation,  he  will  make  the  same  comparison  as  was 
described  in  a  preceding  chapter.  He  will  closely  scru- 
tinize the  values  of  all  fixed  assets,  both  before  and  after 
the  combination  has  been  effected.  The  stability  of 
earnings  and  estimates  for  the  future  will  be  disclosed 
by  the  comparative  income  statement.  The  individual 
and  supplementary  statements  will  only  be  used  by 
him  to  elaborate  and  to  explain  the  consolidated  state- 
ment. Furthermore,  he  must  decide  upon  the  effect 
that  managerial  policies  will  have  on  his  investment,  and 
for  that  purpose  he  will  study  the  individual  statements. 

17.  Other  forms  of  consolidated  statements. — 
While  the  method  just  described  is  the  best,  it  is 
not  the  only  one  employed  for  consolidated  state- 
ments. We  have  already  seen  that  if  a  true 
statement  of  facts  is  presented — the  object  of  any 
and  all  financial  statements — the  form  matters  little. 
If  all  the  required  information  can  be  obtained, 
the    method    of    presenting    it    need    be    considered 


264     FINANCIAL  AND  BUSINESS  STATEMENTS 

only  in  so  far  as  it  affects  the  ease  with  which  such  in- 
formation is  obtainable.  Sometimes  individual  bal- 
ance sheets,  with  explanatory  schedules  of  all  outside 
items  represented  by  the  accounts  "investment  in  sub- 
sidiaries" and  "advances  to  or  from  subsidiaries,"  will 
give  all  the  information  desired.  In  such  a  case,  the 
balance  sheet  of  the  holding  company  will  be  pre- 
sented in  its  customary  form,  while  separate  listings 
of  assets  and  liabilities  and  sources  of  income  and  ex- 
penditure, will  be  presented  in  separate  schedules, 
grouped  according  to  companies.  If  the  amount  of 
detail  involved  and  the  number  of  companies  consid- 
ered is  not  excessive,  this  form  of  statement  will  some- 
times serve  every  purpose. 

As  already  mentioned,  separate  and  complete 
statements  may  be  issued  for  every  company.  The 
holding  company  statement,  together  with  the  finan- 
cial statement  for  each  of  the  subsidiaries,  would  con- 
stitute a  complete  record  of  the  operations  of  the  hold- 
ing company.  Such  a  procedure  does  not  give  the 
kind  of  information  usually  desired  with  that  degree 
of  clearness  with  which  it  is  obtained  thru  the  use  of 
the  consolidated  balance  sheet  or  by  a  separate  listing 
of  the  inter-company  items.  However,  if  the  whole 
organization  is  small  and  the  number  of  constituents 
is  few,  it  may  sometimes  be  satisfactory. 

It  would,  of  course,  be  absurd  to  prepare  a  consoli- 
dated balance  sheet,  or  a  consolidation  of  accounts  of 
companies  totally  dissimilar.  Thus,  if  holding  com- 
pany "A,"  owns  the  entire  stock  of  corporation  "B," 


CONSOLIDATED  BALANCE  SHEETS 


265 


a  company  engaged  in  manufacturing  gas  and  elec- 
tricity, and  also  the  entire  stock  of  corporation  "C," 
which  operates  a  manufacturing  plant,  a  consolida- 
tion of  the  assets  and  liabilities  of  the  underlying  com- 
panies in  this  event,  would  be  meaningless,  if  not  posi- 
tively misleading. 

The  following  illustration  shows  a  consolidated  in- 
come and  profit  and  loss  statement  as  well  as  a  con- 
solidated general  balance  sheet  properly  certified. 

HASKINS  &  SELLS 

Certified  Public  Accountants 

30  Broad  Street 

New  York 


CHICAGO 
Harris  Trust  Building 

CLEVELAND 
Williamson  Building 


SAN  FRANCISCO 
Crocker  Building 

BALTIMORE 
Equitable  Building 


LONDON,  E.  C. 
30  Coleman  Street 

ST.  LOUIS 
Third  National  Bank  Building 

PITTSBURGH 

Farmers  Bank  Building 

Cable  Address   "Hasksells" 

CERTIFICATE 

We  have  audited  the  general  books  and  accounts  of  the 
American  Smelting  &  Refining  Company  and  the  Ameri- 
can Smelters  Securities  Company  for  the  year  ended  De- 
cember 31,  1912,  against  the  related  records  of  original  entry 
and  supporting  documents,  including  monthly  reports  reg- 
ularly received  from  their  various  plants  and  mines,  and 

We  Hereby  Certify,  that,  in  our  opinion,  the  accom- 
panying General  Balance  Sheet  and  Summary  of  Income 
and  Profit  &  Loss  correctly  exhibit,  respectively,  the  consoli- 
dated financial  condition  of  the  Companies  at  December  31, 
1912,  and  their  consolidated  results  for  the  year. 

(Signed)     Haskins  &  Sells, 

Certified  Public  Accountants. 

New  York,  March  5,  1913. 


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n%     FINANCIAL  AND  BUSINESS  STATEMENTS 

REVIEW 

Since  the  stock  of  subsidiary  companies  is,  as  a  rule,  purchased 
at  a  premium,  how  shall  excess  of  price  over  book  value  of 
assets  be  treated  in  books  of  parent  company? 

What  four  kinds  of  surplus  can  a  holding  company  have? 
Explain  how  they  differ. 

What  different  purposes  do  consolidation  balance  sheets  serve, 
and  how  does  this  affect  their  construction  and  the  explanatory 
matter  which  accompanies  them? 


CHAPTER  XX 

PRIVATE  BUDGETS 

1.  Purpose  and  definition  of  budgets, — The  va- 
rious forms  of  financial  and  other  statements,  pre- 
viously discussed,  deal  with  transactions  which  have 
occurred  in  the  past.  They  indicate  the  success  or 
failure  of  transactions  already  completed  or  in  the 
course  of  completion.  The  business  manager  of  to- 
day, however,  in  many  cases,  requires  information  on 
the  conditions  which  may  be  expected  in  the  future. 
This  information  must  be  in  the  form  of  a  scientif- 
ically prepared  and  classified  statement  of  the  future, 
and  not  a  haphazard  or  indefinite  forecasting.  It 
must  be  a  complete  budget,  based  upon  the  best  data 
obtainable  from  the  recorded  results  of  the  past. 

2.  The  annual  budget. — The  annual  budget  is  a 
detailed  statement  or  program,  outlining  the  financial 
plans  of  the  management  for  the  coming  year  and  the 
methods  by  which  it  proposes  to  accomplish  these 
plans.  This  statement  calls  for  a  careful  estimate  of 
the  total  income  or  revenue  from  sales  of  product  or 
service,  which  it  is  expected  will  be  realized  during  the 
year.  It  also  calls  for  a  careful  estimate  of  the  entire 
cost  of  operation  during  the  year,  showing  separately 

273 


274     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  cost  of  each  individual  department  and  sub-sched- 
ules of  the  cost  of  operation  within  departments. 

3.  Interim  reconciliation  of  estimate  with  costs, — 
In  order  that  the  management  may  be  informed  as  to 
the  actual  working  out  of  the  predetermined  outlay 
and  income  during  the  fiscal  year,  there  should  be  fur- 
nished a  periodical  statement  which  may  be  made  up 
semi-annually,  quarterly  or  monthly.  This  state- 
ment should  disclose  the  exact  financial  condition  at 
the  beginning  and  at  the  end  of  the  period  and  the 
actual  outlay  of  each  department  or  operation  during 
the  period.  A  comparison  of  these  costs  with  those 
for  similar  periods  in  previous  years  should  be  made. 
The  balance  of  the  appropriation,  which  remains  to 
each  department  for  its  operations  during  the  re- 
mainder of  the  fiscal  year,  should  also  be  shown. 

4.  The  final  statement. — At  the  end  of  the  fiscal 
year,  the  final  statement  should  show  a  comparison  of 
the  actual  results  with  the  predetermined  results. 
The  revenue  received  on  account  of  each  departmental 
function,  or  unit  of  service,  will  be  compared  with  the 
predetermined  estimate,  and  the  actual  cost  will  be 
contrasted  with  the  predetermined  cost. 

5.  Value  and  use  of  estimates. — The  value  and 
use  which  can  be  made  of  these  estimates  is  evident 
when  we  realize  that  the  success  of  a  business  enter- 
prise is  dependent  chiefly  upon  the  ability  of  the  man- 
agement to  plan  intelligently  for  the  future,  and  that 
a  large  percentage  of  business  failures  is  directly 
traceable  to  neglect  in  anticipating  financial  needs  in 


PRIVATE  BUDGETS  275 

time  to  provide  for  them.  Construction  work,  provi- 
sion for  the  expansion  of  business,  increased  sales,  ris- 
ing costs  of  production,  etc.,  must  be  anticipated  and 
provided  for  before  they  actually  arise.  The  diversi- 
fication of  industry  and  the  constantly  increasing 
necessity  of  depending  upon  indirect  supervision  and 
management,  together  with  rapidly  changing  business 
conditions,  necessitates  the  use  of  scientifically  pre- 
pared forecasts. 

6.  Budgets  as  a  means  of  guidance, — A  budget 
guides  the  executive  in  developing  policies,  by  fore- 
casting the  effects  and  results  of  these  policies.  It 
insures  financial  preparedness  by  indicating  financial 
needs  before  they  actually  arise. 

The  estimate  sheets  of  the  different  departments 
are  in  turn,  indicated  by  means  of  departmental  bud- 
gets. These  are  grouped  into  one  general  budget, 
covering  the  needs  of  the  business  as  a  whole.  The 
departmental  budgets  serve  as  guides  to  the  depart- 
mental heads,  and  their  operations  during  the  period 
will  be  governed  by  their  departmental  budgets. 

7.  Special  budgets. — In  addition  to  the  general 
and  departmental  budgets,  which  may  be  designated 
as  regular  budgets,  it  is  occasionally  necessary  to  pre- 
pare a  special  budget  for  a  particular  purpose.  Such 
purpose  may  be  that  of  attempting  to  forecast  the 
effects  and  results  of  a  particular  policy  or  of  condi- 
tions in  a  particular  department.  For  example,  the 
management  may  wish  to  know  how  a  proposed  in- 
crease in  the  kinds  of  goods  produced  will  work  out. 


276     FINANCIAL  AND  BUSINESS  STATEMENTS 

A  budget  may  be  prepared  showing  just  how  this 
change  will  affect  the  growth  of  the  business  and  how 
practicable  the  venture  will  be.  Special  budgets  are 
used  at  times  to  supplement  the  regular  budgets  when 
changes  in  conditions  have  been  so  extreme  as  to  ren- 
der the  original  departmental  budget  valueless. 

8.  The  sub-division  of  budgets  into  monthly 
periods. — For  practical  use,  a  budget  should  be  sub- 
divided into  monthly  periods.  The  operations  of  one 
department  may  not  synchronize  with  those  of  another 
and  while  the  budget  covers  the  operations  of  the  fiscal 
year,  the  management  must  forecast  the  conditions 
at  all  times  between  the  beginning  and  the  end  of  the 
year.  It  very  frequently  happens  that  at  some  time 
within  the  fiscal  year,  the  amount  of  obligations  pay- 
able will  temporarily  exceed  the  amount  of  the  cash 
and  receivables  available  to  meet  them,  thus  making  it 
incumbent  upon  the  management  to  have  sufficient 
funds,  either  owned  or  borrowed,  to  meet  the  imme- 
diate needs  at  that  particular  time.  If  the  budget  is 
prepared  on  a  monthly  basis,  this  information  will  be 
at  hand,  and  the  proper  financial  preparations  can  be 
made. 

9.  Pre-requisites  of  a  budget. — A  satisfactory  and 
efficient  accounting  system  is  a  pre-requisite  to  the 
preparation  of  an  intelligent  forecast  of  future  con- 
ditions. The  accuracy  of  the  budget  will  depend  in 
great  measure  upon  the  accuracy  with  which  past 
transactions  can  be  interpreted.  This  means  that  in 
most  cases  it  will  be  necessary  to  have  proper  cost 


PRIVATE  BUDGETS  277 

records  in  order  to  ascertain  with  as  much  certainty  as 
possible,  the  cost  of  the  goods  which  are  expected  to 
be  sold  during  the  ensuing  year. 

10.  Budget  routine, — It  is,  of  course,  impossible 
to  lay  down  a  budget  routine  that  will  apply  in  prac- 
tice to  every  individual  case.  The  budget  informa- 
tion for  each  department  must,  of  necessity,  be  ini- 
tiated by  the  men  who  are  responsible  for  the  depart- 
ment, and  who  are,  therefore,  most  familiar  with  the 
actual  working. 

In  this  connection,  the  department  head  should  en- 
courage a  general  discussion  of  the  subject  with  his 
subordinates  and  the  views  of  every  man  who  can  offer 
helpful  advice,  should  be  considered.  The  plans  and 
program  for  the  ensuing  year  should  first  be  out- 
lined. A  statement  should  be  made  of  the  antici- 
pated income  or  revenue  to  be  received  by  the  depart- 
ment, together  with  a  careful  estimate  of  the  costs  in 
minute  detail.  In  some  instances,  it  will  be  neces- 
sary to  reverse  the  order,  first  to  determine  the  cost 
and  then  upon  the  basis  of  the  figures  of  the  estimated 
cost  to  measure  the  appropriation  which  the  depart- 
ment is  to  ask  for,  to  cover  its  operations  during  the 
year.  When  this  information  has  been  carefully  an- 
alysed and  when  from  the  experience  of  the  past,  the 
estimates  of  the  future  have  been  determined,  a  de- 
tailed statement  should  be  prepared  by  a  uniform 
method,  which  all  departments  or  functions  will  em- 
ploy. The  estimate  is  then  submitted  to  the  execu- 
tive, usually  the  treasurer  or  president,  for  approval. 


278     FINANCIAL  AND  BUSINESS  STATEMENTS 

In  some  instances,  department  heads  may  not  have 
available  the  necessary  information  as  to  costs  and, 
in  this  case,  the  records  of  past  transactions  must  be 
obtained  from  the  accounting  department.  The  ex- 
hibit on  page  287  shows  merely  by  way  of  sugges- 
tion, the  general  budget  of  a  small  manufacturing 
concern. 

11.  Sales  department's  duties  as  to  budgets. — 
The  sales  department  should  furnish  an  estimate  of 
the  possible  output  for  the  ensuing  year  based  upon 
the  records  of  the  past,  and  influenced  by  anticipated 
business  conditions.  In  this  connection  the  effect  of 
a  proposed  change  in  prices  will  be  considered.  It 
will  be  seen  that  the  accuracy  of  the  estimate  depends 
in  a  great  measure  upon  the  skill  with  which  the  gen- 
eral trend  in  business  conditions  is  forecasted.  In 
actual  practice  this  will  not  present  the  same  difficulty 
as  it  does  in  theory;  if  the  budgets  of  previous  years 
are  studied  in  comparison  with  the  actual  results  of 
the  same  years,  mistakes  in  judgment  will  not  be  re- 
peated. As  in  other  things,  experience  is  a  great 
teacher  and  budget  makers  will  find  that  their  es- 
timates will  become  more  and  more  accurate  from 
year  to  year.  In  the  majority  of  cases,  not  more  than 
from  two  to  five  per  cent  of  the  estimates  will  be  found 
to  be  inaccurate. 

12.  Budgets  on  four-week  instead  of  calendar- 
month  basis. — A  recent  step  in  accounting  work  and 
budget  preparation  has  been  that  of  basing  all  reports 


PRIVATE  BUDGETS  279 

on  four  week  periods  rather  than  on  calendar  months. 
This  plan  has  become  especially  popular  in  cost  ac- 
counting. Its  chief  value  lies  in  the  fact  that  it  fur- 
nishes a  much  better  basis  for  comparison  because  of 
the  even  periods  of  time  involved. 

13.  Duties  of  production  department. — Based 
upon  the  estimate  of  the  sales  manager  for  the  ensu- 
ing year,  the  production  department  will  then  be  in 
a  position  to  make  its  estimate.  The  purchasing  de- 
partment must  investigate  the  market  conditions,  de- 
termine whether  the  raw  and  indirect  material  may 
be  procured  in  sufficient  quantity  to  meet  the  demands 
of  the  anticipated  orders  and  a  forecast  must  be  made 
of  the  probable  prices  that  will  have  to  be  paid  for 
such  materials.  It  may  be  possible,  for  example,  to 
purchase  the  entire  year's  supply  of  raw  materials  at 
prices  much  less  than  may  be  obtained  later.  The 
effect  of  such  a  purchase  on  the  profits  of  the  period, 
and  a  comparison  between  the  benefits  to  be  received 
from  immediate  purchase  of  the  raw  materials,  and 
their  purchase  distributed  over  the  year  should  be 
considered. 

The  ability  of  the  concern  to  finance  such  a  transac- 
tion will  have  an  important  bearing  upon  the  pro- 
cedure to  be  adopted.  The  purchasing  agent  of  a 
large  railway  supply  house  at  the  beginning  of  the 
European  war  prepared  his  budget  upon  the  as- 
sumption that  the  price  of  copper  would  increase  and 
convinced  the  executives  that  the  proper  thing  to  do 


280     FINANCIAL  AND  BUSINESS  STATEMENTS 

was  to  anticipate  the  requirements  for  a  year  or  more 
if  the  organization  would  be  financially  able  to  carry 
the  transaction  thru. 

The  factory  heads  in  the  case  of  a  manufacturing 
concern  must  be  able  to  predetermine  the  output.  It 
may  be  that  the  price  of  labor  will  vary  at  different 
times  during  the  year.  This  is  true,  especially  in 
certain  of  the  garment-making  industries.  If  sales 
and  production  can  be  predetermined  with  a  fair  de- 
gree of  accuracy,  it  may  be  possible  to  manufacture 
during  the  time  when  labor  is  relatively  cheaper. 

On  the  other  hand,  the  budget  may  serve  to  equalize 
production  over  the  year  instead  of  having  the  greater 
part  of  the  work  concentrated  in  a  few  months.  The 
manufacture  of  stock  within  the  limit  of  estimated 
sales  would  reduce  the  stress  of  the  heavy  business 
periods  and  cheapen  the  cost  of  production.  It  will 
thus  be  seen  that  the  production  manager  and  the  pur- 
chasing agent  must  work  hand  in  hand  so  that  the 
latter  may  plan  his  future  purchases  so  as  to  secure 
the  best  possible  price  and  the  delivery  of  material  at 
the  time  the  production  manager  requires  it. 

Thus,  we  see  that  each  department  is  dependent 
upon  some  other  and  that  we  will  have  a  series  of 
reports,  each  report  based  in  part  upon  the  es- 
timated needs  of  the  other  related  departments,  each 
one  dovetailing  into  the  others.  Each  departmental 
report  must  be  complete  and  should  be  accompanied 
by  explanatory  schedules  where  necessary. 

14.  Assembling   the   data. — The   actual   work   of 


PRIVATE  BUDGETS  281 

classifying,  grouping  and  assembling  all  these  reports 
into  one  general  comprehensive  budget  can  best  be 
performed  in  the  treasurer's  department.  While  each 
department  is  preparing  its  estimate,  the  treasurer 
should  make  up  a  comparative  statement  in  budget 
form  of  the  actual  receipts  and  disbursements  of  sev- 
eral prior  periods,  and  also  a  list  of  all  special  pay- 
ments or  receipts  for  the  next  year  which  are,  as  a 
rule,  known  only  to  the  financial  division.  Items  of 
this  kind  will  cover,  for  example,  advances,  loans,  in- 
terest, investments,  construction  requirements  or  the 
possible  sale  of  securities  either  stock  or  bonds.  By 
the  use  of  a  comparative  report  of  previous  years'  op- 
erations and  the  departmental  estimates,  the  actual 
work  of  preparation  is  facilitated. 

All  revenues  and  expenses  are  dependent  upon  four 
factors ;  namely,  the  amount  of  business  expected,  the 
anticipated  cost,  general  business  conditions,  and  ex- 
traordinary plans  or  projects.  Subject  to  the  trend 
in  general  business  conditions  and  any  changes  in  cost, 
the  expenses  will  increase  or  decrease  over  previous 
years  in  proportion  to  the  increase  or  decrease  in  the 
amount  of  sales.  The  first  step,  then,  is  to  arrive  at 
a  budget,  based  solely  upon  proportionate  changes  as 
compared  with  the  actual  conditions  or  transactions 
of  previous  periods.  Increased  or  decreased  costs, 
good  or  bad  general  business  conditions,  new  under- 
takings, new  conditions  in  departments,  and  the  like, 
will  each  tend  to  alter  the  budget  and  hence,  each 
must  be  given  careful,  individual  consideration. 


282     FINANCIAL  AND  BUSINESS  STATEMENTS 

Reference  to  the  accounting  records  will  often  aid 
in  determining  the  influence  of  these  unusual  circum- 
stances. The  effects  of  previous  changes  will  be 
clearly  shown  and  from  these  we  can  draw  inferences 
as  to  the  effect  of  the  present  changes.  In  any  event, 
we  can  estimate  these  changes  as  being  a  certain  per- 
centage above  or  below  normal  and  adjust  our  budget 
accordingly. 

To  these  figures  must  be  added  the  items  of  possible 
receipts  and  expenditures  already  listed.  Construc- 
tion to  be  financed  by  loans  should  be  so  designated 
in  the  budget,  and  only  such  portions  of  payments  on 
account  of  construction  or  repairs  as  fall  due  in  a 
budget  period,  should  be  considered.  This  provision 
also  holds  good  in  connection  with  other  items,  as  a 
budget  estimate  covers  only  cash  transactions  occur- 
ring within  a  budget  period. 

15.  Checking  the  data  assembled. — The  assembled 
data  should  be  carefully  revised  and  checked.  One 
department  or  function  may  have  planned  certain 
changes  which  call  for  increase  in  appropriation,  and 
the  management  may  disagree  with  the  department 
head.  Then  it  becomes  the  latter's  duty  to  justify  his 
expenditure — to  try  to  "sell"  his  idea  to  the  executives. 
If  he  succeeds  in  doing  this,  his  estimate  will  be  al- 
lowed to  remain;  otherwise  it  will  have  to  be  aban- 
doned. The  production  department  or  the  factory 
superintendent  may  foresee  the  necessity  of  a  general 
increase  in  the  wages  of  factory  employes;  it  may  be 
that  he  had  not  enough  breadth  of  vision  to  foresee  the 


PRIVATE  BUDGETS  283 

necessity,  and  his  estimate  based  upon  past  labor  costs 
will  have  to  be  revised. 

The  assembling  of  the  data,  the  balancing  of  es- 
timates, the  revision  by  the  executive  of  the  financial 
department,  the  predetermination  of  costs  within  the 
limit  of  the  receipts  as  fixed  by  the  sales,  constitute 
the  scientific  part  of  budget  preparation.  The  dove- 
tailing of  the  schedule  of  one  department  of  the  or- 
ganization to  those  of  other  departments  and  the  weld- 
ing of  all  into  a  comprehensive  whole,  calls  for  the 
exercise  of  prudence  and  judgment.  The  budget  in 
its  final  form  after  being  passed  by  the  treasurer  or 
financial  officer  best  qualified  to  assemble  it,  is  sub- 
mitted to  the  board  of  directors  for  their  examination 
and  approval. 

After  approval  by  the  board  of  directors  or  by  the 
management,  the  budget  becomes  the  treasurer's 
financial  guide.  He  is  enabled  to  make  such  disposi- 
tion of  the  funds  as  will  enable  him  to  handle  them 
most  economically,  and  yet,  always  to  have  sufficient 
funds  on  hand  to  meet  whatever  payments  fall  due. 
This  reason  alone  makes  it  necessary  that  the  appro- 
priations of  the  budget  be  closely  followed.  The 
treasurer  would  be  in  constant  trouble  if  the  depart- 
mental heads  were  permitted  to  spend  the  money  with- 
out conforming  to  the  standard  which  they  had  pre- 
viously set. 

16.  Interim  check  on  the  budget. — For  this  rea- 
son, therefore,  the  periodical  statements  mentioned 
above  must  be  prepared  to  show  the  actual  receipts 

XXII— 20 


284     FINANCIAL  AND  BUSINESS  STATEMENTS 

and  expenditures  as  compared  with  the  estimated 
budget.  The  statement  will  thus  act  as  a  check  on 
the  company's  operations  and  on  the  accuracy  of  the 
budget  estimate.  Any  great  discrepancy  between  the 
actual  transactions  and  the  estimates  must  result  from 
one  of  three  causes:  estimates  may  have  been  care- 
lessly prepared;  the  department  heads  may  have  de- 
parted from  the  program  which  they  set  up;  or,  un- 
usual outside  conditions  may  have  brought  about  the 
change. 

In  any  event,  these  discrepancies  should  be  investi- 
gated and  explained.  They  are  signals — sometimes 
danger  signals — and  must  not  be  ignored.  Thus,  the 
reader  will  see  that  the  budget  forms  a  reasonably  ac- 
curate forecast  of  the  future  conditions  to  be  met  by 
the  management.  It  serves  as  a  general  guide  in  that 
it  often  forestalls  mistakes  and  unwise  moves,  or,  at 
least,  points  them  out  in  time  to  avoid  great  loss.  The 
budget  forms  the  basis  for  a  revision  of  plans  when 
changing  conditions  make  a  revision  necessary.  Un- 
less the  management  has  some  guide  by  which  to 
gauge  the  concern's  progress,  it  will  not  be  able  to  tell 
at  once  when  a  change  in  plans  is  desirable,  and  losses 
or  misdirected  efforts  must  result. 

17.  Other  considerations  in  budget  making, — 
Even  when  loans  are  not  regularly  resorted  to  as  a 
means  of  financing  a  business,  it  may  often  be  found 
that  demands  for  cash  at  various  times  during  the 
year  will  require  temporary  borrowing.  Borrowing 
then,  within  the  limits  of  credit,  forms  the  balancing 


PRIVATE  BUDGETS  285 

medium  of  the  budget.  If  the  borrowings  are  caused 
by  factors  within  the  control  of  the  executives,  the 
raising  of  the  loans  may  be  avoided  by  abandoning 
that  part  of  the  work  which  necessitates  the  extra 
money. 

18.  Working  back  from  the  income  statement. — 
In  some  of  our  large  corporations,  particularly  the 
public  service  corporations,  it  is  sometimes  difficult 
to  work  up  a  budget  based  upon  actual  cash  transac- 
tions. These  corporations  may  make  up  an  estimated 
income  and  expenditure  statement  based  upon  the 
principles  which  have  just  been  discussed.  In  order 
to  arrive  at  the  actual  cash  transaction  involved  in  this 
income  and  expenditure  statement,  it  is  necessary  to 
eliminate  all  items  not  represented  by  actual  cash  re- 
ceipts or  payments  that  occur  during  the  fiscal  period 
under  consideration. 

This  practice,  however,  is  not  to  be  recommended, 
because  it  is  less  accurate  than  the  plan  which  we  have 
outlined  before,  and,  furthermore,  does  not  provide 
for  a  monthly  statement  of  the  transactions  involved. 
There  seems  to  be  little  doubt  that  even  the  larger 
corporations  can  secure  estimates  from  their  depart- 
ment heads  regarding  the  actual  cash  transactions  to 
be  made  during  the  year. 

There  are,  perhaps,  certain  lines  of  business  in 
which  the  budget  idea  may  not  be  suitable.  The  gen- 
eral opinion  among  certain  public  service  corporations 
for  example,  is  that  a  budget  is  not  practical.  Even 
in  these  cases,  however,  an  attempt  is  made  to  estab- 


2S6     FINANCIAL  AND  BUSINESS  STATEMENTS 

lish  a  construction  budget.  The  amount  of  quick  as- 
sets available,  and  the  amount  to  be  secured  by  new 
financing  will  furnish  the  funds  needed  to  finance  new 
construction.  Based  upon  this  estimate,  the  con- 
struction program  for  the  following  year  is  outlined. 

19.  Departmental  standards  required  for  budget 
making, — The  departmental  budgets  are  especially 
valuable  in  holding  department  heads  to  given  stand- 
ards. The  departments  have  certain  allowances  for 
expenditures  and  are  required  to  produce  certain  re- 
sults in  return.  Any  deviation  from  the  standard 
must  be  due  to  unusual  conditions  or  to  a  fluctuation 
in  managerial  efficiency.  Often  departmental  bud- 
gets cover  all  the  operations  and  activities  of  the 
departments  by  setting  arbitrary  limits  outside  of 
which  the  department  manager  has  no  authority.  It 
is  doubtful,  however,  if  such  rigid  control  is  advis- 
able in  any  but  exceptional  cases. 

The  departmental  budget  also  serves  to  equalize 
production  not  only  according  to  time,  but  also  ac- 
cording to  the  needs  of  other  departments  whose  work 
may  be  related  to  that  of  the  department  in  question. 
If  the  budget  requirements  for  each  department  re- 
late satisfactorily  to  each  other,  then  the  actual  work 
that  is  carried  on  in  accordance  with  the  budget  re- 
quirements should  interlock  efficiently. 


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288     FINANCIAL  AND  BUSINESS  STATEMENTS 

REVIEW 

Explain  the  relation  of  a  budget  to  the  accounting  system. 

Should  the  budget  be  made  only  on  an  annual  basis  or  for 
shorter   intervals?     Give  reasons   for   decision  of  this   question. 

Describe  the  share  of  the  sales  department,  the  production 
department,  and  the  treasurer  in  the  preparation  of  a  budget. 

How  far  is  the  budget  idea  applicable  and  what  are  the  ad- 
vantages which  result  from  its  use? 


CHAPTER  XXI 

MUNICIPAL  BUDGETS 

1.  Development  of  municipal  budgets. — It  has 
always  been  necessary  for  some  part  of  the  govern- 
mental agencies,  either  the  administrative  or  the  legis- 
lative, to  prepare  rough  estimates  of  the  necessary 
expenses  of  the  corporation  for  the  ensuing  fiscal 
year.  This  information  was  used  as  a  basis  for  tax 
levies.  For  many  years,  this  work  was  undertaken 
in  a  haphazard  and  unscientific  way.  The  gradual 
development  of  the  science  of  government,  the  in- 
creasing demands  made  upon  municipalities  for  fur- 
ther improvements,  and  the  constantly  increasing  mu- 
nicipal debts  of  our  American  cities  have  forced  the 
authorities  to  adopt  some  systematic  plan  for  finan- 
cing and  controlling  the  expenditures  of  municipal 
corporations.  Furthermore  the  authorities  realize 
that  business  methods,  by  which  a  complete  check  is 
had  on  all  transactions  and  operations,  are  as  impor- 
tant in  the  management  of  municipal  activities  as  they 
are  in  business  organizations. 

2.  Distinction  between  private  budgets  and  mu- 
nicipal budgets. — In  the  preparation  of  private  bud- 
gets, the  reader  noticed  that  it  was  necessary  to  limit 
the  expenditures  of  the  fiscal  period  by  the  amount  of 

289 


290     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  expected  receipts.  No  such  limits  are  placed 
upon  the  makers  of  municipal  budgets.  The  expen- 
ditures are  determined,  then  the  revenue  is  adjusted 
to  correspond.  This  statement  must  be  qualified,  for 
tax  levies  and  other  municipal  charges  must  not  be 
exorbitant.  Furthermore,  the  tax  levy  is  offset  by 
the  amount  of  certain  incomes  which  municipalities 
receive  for  water  rates,  dock  and  ferry  privileges,  in- 
vestments in  rapid  transit  enterprises,  license  and 
court  fees,  etc. 

A  municipal  budget,  then,  is  a  comprehensive,  de- 
tailed plan  or  program  of  the  work  to  be  accom- 
plished by  the  administration  during  the  ensuing  year, 
together  with  a  detailed  estimate  of  the  cost  thereof, 
covering  all  departments  and  all  operations  of  the 
municipality.  By  the  use  of  this  plan,  the  taxpayers 
are  enabled  to  check  up  the  work  of  their  represen- 
tatives and  the  chief  administrative  officer  is  enabled 
to  have  a  check  on  the  acts  of  his  subordinates  by  hold- 
ing them  to  the  limits  of  the  budget.  Furthermore,  it 
gives  the  controller  a  record  against  which  he  may 
judge  the  various  departmental  warrants  or  checks, 
which  are  presented  to  him  for  payment.  As  a  rule 
he  has  no  authority  to  make  payments  in  excess  of  the 
amount  allotted  in  the  budget  to  a  particular  depart- 
ment or  division. 

To  the  department  head,  the  municipal  budget  be- 
comes an  arbitrary  guide  in  the  making  of  purchases 
or  in  operating  his  department.  He  has  definite 
limits  set  for  him  as  to  the  expenditures  which  he  can 


MUNICIPAL  BUDGETS  291 

make.  He  knows  that  certain  results  in  actual  work, 
laid  down  at  the  beginning  of  the  year  in  the  financial 
program,  are  expected  in  return  for  his  expenditures. 
He  must  not  only  keep  his  withdrawals  within  the 
limits  of  the  budget,  but  he  must  obtain  for  these 
withdrawals  a  maximum  of  results  and  the  comple- 
tion of  the  program  laid  down  in  the  original  estimate. 
3.  Borrowing  by  municipal  and  business  organiza- 
tions differentiated. — The  reader  has  seen  that  the 
private  budget  serves  to  keep  the  business  house  sup- 
plied with  sufficient  funds  to  meet  its  obligations. 
The  municipal  budget  on  the  other  hand,  while  serv- 
ing this  purpose  to  a  limited  degree,  does  not  always 
result  in  that  desirable  end.  Municipal  taxes  are  fre- 
quently not  collected  until  the  latter  part  of  the  year, 
while  the  expenditures  chargeable  to  the  budget  ap- 
propriation, begin  to  accrue  immediately.  Many  mu- 
nicipalities have  now  adopted  the  plan  of  having  taxes 
payable  semi-annually.  This  reduces  the  necessities 
of  borrowing  and  results  in  a  considerable  saving  of 
interest  for  the  municipalities.  In  a  recent  address, 
Hon.  William  A.  Pendergast,  controller  of  the  City 
of  New  York,  illustrated  the  saving  which  New  York 
City  made  by  providing  for  the  collection  of  taxes 
twice  a  year. 

In  1906,  on  a  tax  levy  of  $94,000,000,  the  city  paid  in  in- 
terest, on  revenue  bonds  issued  in  anticipation  of  the  collec- 
tion of  taxes,  $2,898,562. 

In  1909,  on  a  tax  levy  of  $122,750,000,  the  city  paid  in 
interest,  on  revenue  bonds  issued  in  anticipation  of  the  collec- 
tion of  taxes,  $5,194,241. 


292     FINANCIAL  AND  BUSINESS  STATEMENTS 

In  1912,  under  the  semi-annual  tax  plan,  on  a  levy  of 
$150,500,000,  the  city  paid  in  interest,  on  revenue  bonds  is- 
sued in  anticipation  of  the  collection  of  taxes,  only 
$2,479,635. 

Thus,  it  will  be  seen  that  the  municipal  budget  does 
not  seek  to  provide  the  funds  at  the  time  when  they 
are  needed,  as  is  the  plan  of  a  private  budget,  but  it 
is  interesting  to  note  that  progress  has  been  made  in 
this  respect,  and  that  municipal  authorities  are  alive 
to  the  evil  of  interest  charges  and  large  floating  debts. 

4.  Old-time  budgets. — Under  the  old-time  (so- 
called)  budget  system,  each  department  head  fur- 
nished the  legislative  body  with  a  lump  estimate  of 
the  needs  of  his  department.  This  method  was  open 
to  numberless  objections.  Inasmuch  as  the  appro- 
priation was  made  in  one  lump  sum  for  the  depart- 
ment, all  possible  avenues  for  misapplication  of  the 
funds  were  open.  The  amount  which  was  to  be  ex- 
pended for  salaries  was  not  stated,  nor  was  the  amount 
to  be  expended  for  any  one  of  the  department's  usual 
needs  specified  in  the  budget.  Consequently,  there 
was  open  to  the  head  of  the  department  the  oppor- 
tunity of  diverting  funds,  which  should  have  been 
used  for  the  real  needs  of  the  department,  to  improper 
purposes. 

When  the  legislative  bodies  began  to  prune  the  de- 
partment head's  estimates,  the  department  head  sim- 
ply increased  his  estimate  above  the  figure  which  he 
actually  expected  to  get.  Any  reduction  by  the  leg- 
islative body  simply  tended  to  bring  his  particular 


MUNICIPAL  BUDGETS  293 

allotment  down  to  the  amount  which  he  actually  de- 
sired. 

5.  The  modem  budget. — The  modern  budget 
takes  several  different  forms,  but  is  founded  on  the 
idea  of  a  collateral  check  and  investigation  of  the 
estimates  submitted  by  department  heads.  The  de- 
partment heads  are  expected  to  confer  with  those 
qualified  under  them  and  submit  an  estimate  which 
measures,  as  accurately  as  can  be  foreseen,  the  actual 
needs  for  the  ensuing  period.  There  are  two  kinds 
of  budgets  now  in  use,  the  segregated  and  the  lump- 
sum, which,  while  varying  somewhat  in  form,  are 
practically  representative  of  modern  municipal  budget 
practice. 

6.  The  segregated  budget. — The  segregated  bud- 
get provides  a  very  complete  and  absolute  check  on 
the  operations  of  every  department.  Departmental 
estimates  are  submitted  on  a  form  which  calls  for  de- 
tailed information  in  support  of  the  requests  made  by 
the  department  head.  All  proposed  expenditures  are 
itemized  in  detail  so  as  to  make  them  readily  com- 
parable with  the  transactions  of  previous  years.  The 
definite  appropriation  of  sums  for  specific  purposes 
prevents  the  diversion  of  funds  to  objects  other  than 
those  for  which  they  were  designated.  The  depart- 
ment head  has  a  fixed  allowance  for  salaries  and  other 
expenses,  and  there  is  no  opportunity  for  him  to  util- 
ize any  part  of  the  appropriation  for  other  purposes 
without  securing  the  necessary  authority  for  so  doing. 
Under  this  method,  estimates  are  in  such  a  shape  that 


294     FINANCIAL  AND  BUSINESS  STATEMENTS 

they  may  be  subjected  to  intelligent  scrutiny  by  ex- 
pert examiners  of  a  budget  commission  or  by  any  one 
interested. 

This  method  has  many  disadvantages  which  will 
often  defeat  its  purpose:  a  considerable  expense  is 
entailed  in  the  employment  of  a  large  clerical  and 
examining  staff;  rigid  classification  will  frequently 
hamper  the  heads  of  departments  and  handicap  them 
greatly  in  their  work;  it  is  so  inflexible  that  any  un- 
foreseen contingencies  or  changed  conditions  cannot 
be  satisfactorily  provided  for.  On  the  other  hand,  if 
the  idea  of  segregation  is  carried  out  with  judgment, 
it  will  prove,  as  a  rule,  efficient  in  operation. 

7.  The  lump-sum  budget, — This  method  is  di- 
rectly opposed  to  the  segregated  budget  in  many  of 
its  features.  Under  this  plan,  the  estimate  for  each 
department  is  expressed  in  a  lump  sum.  However,  to 
overcome  the  disadvantages  of  a  lump  sum  appro- 
priation unsupported  by  further  details,  and  in  order 
still  to  maintain  the  flexibility  of  the  operation  of  the 
lump  sum  budget,  cost  schedules  and  working  plans 
are  made  a  part  of  the  budget.  These  cost  schedules 
and  work  plans  must  cover  the  complete  operation  of 
the  department.  The  current  year's  expenses,  the 
program  of  work  to  be  covered,  and  a  working  plan 
of  the  effects  of  this  year's  projects  on  ensuing  years 
must  be  made  a  part  of  the  estimate.  This  method 
provides  for  the  carrying  thru  of  new  projects  to 
their  completion  even  tho  the  administration  changes. 
The  lump-sum  budget  system  has  shortcomings  as 


MUNICIPAL  BUDGETS  295 

well  as  advantages.  There  is  no  way  of  keeping  a 
department  head  strictly  within  his  appropriation, 
for,  unless  the  cost  schedules  are  made  a  mandatory 
part  of  the  budget,  he  has  full  power  to  shift  funds 
at  his  pleasure.  On  the  other  hand,  as  soon  as  the 
cost  schedules  are  made  rigid  and  controlling,  the 
lump-sum  budget  becomes,  in  effect,  a  segregated 
budget. 

8.  A  variation  of  the  lump-sum  budget  plan. — 
Under  this  method,  the  appropriation  is  not  arbi- 
trarily fixed  for  the  entire  year.  In  order  to  obtain 
the  advantages  of  the  segregated  budget  and  the  flexi- 
bility of  the  lump-sum  budget,  the  budget  commis- 
sion will  make  quarterly  allotments  of  the  appropria- 
tion for  the  necessary  purposes  during  that  quarter. 
This  practically  results  in  a  quarterly  examination  of 
the  department  and  its  needs.  The  allotment  cannot 
be  made  unless  the  budget  commission  is  thoroly  fa- 
miliar with  the  conditions  and  plans  of  the  depart- 
ment. It  results  in  a  segregated  budget,  or,  rather, 
a  classification  of  expenses  for  the  ensuing  quarter. 

9.  The  essentials  of  municipal  budget  preparation. 
— In  the  first  place,  it  is  necessary  in  the  preparation 
of  a  budget  that  the  transactions  of  previous  years  be 
compared  and  used  as  a  basis  for  the  appropriation 
for  the  ensuing  period.  The  estimates  should  give 
details  with  such  minuteness  and  in  accordance  with 
such  standard  classifications  as  will  enable  the  com- 
parison to  be  made.  Second,  estimates  should  be  pre- 
pared by  department  heads  with  the  aid  of  their  sub- 


296     FINANCIAL  AND  BUSINESS  STATEMENTS 

ordinates.  As  in  a  private  business,  every  opinion  of 
weight  in  the  division  or  department  should  be  called 
for  at  the  time  the  estimates  of  the  budget  are  first 
being  made  up.  Third,  the  estimates  should  be  sub- 
sequently examined  and  investigated  by  some  person 
who  is  familiar  with  the  details  and  needs  of  each  de- 
partment but  who  is  not  connected  with  any  of  them. 
This  may  require  the  services  of  an  independent  in- 
vestigation bureau.  Fourth,  the  estimates  should  be 
considered  at  public  hearings  at  which  interested  tax- 
payers may  discuss  any  details  to  which  they  object  or 
in  which  they  are  otherwise  interested.  Fifth,  the 
budget  should  not  grant  a  lump  sum  to  any  depart- 
ment which  it  may  spend  in  any  way  it  pleases.  The 
budget  should  be  segregated  sufficiently  to  allow  a 
reasonable  check  on  the  actions  of  the  department 
heads.  The  department  head  should  be  required  to 
make  the  best  use  of  whatever  funds  are  at  his  dis- 
posal. Sixth,  the  budget  must  be  founded  on  law 
and  based  upon  clear  and  honest  accounting  records. 
10.  Legal  foundation  for  budget  necessary. — To 
be  successful  in  operation,  a  budget,  no  matter  what 
its  form,  must  be  founded  on  law.  Its  features  of 
administrative  and  financial  control  will  not  operate 
to  any  advantage  unless  they  are  compulsory.  His- 
tory furnishes  one  or  two  instances  where  the  chief 
executive  has  tried  to  follow  out  a  budget  plan  with- 
out securing  the  passage  of  a  budget  law.  His  at- 
tempts, while  commendable,  were  not  successful  be- 
cause he  could  not  secure  the  cooperation  of  the 


MUNICIPAL  BUDGETS  297 

legislative  body  and  of  his  subordinates.  The  law 
prescribing  a  system  of  budget  preparation  must  be 
complete  in  all  details  and  must  lay  down  the  rules  of 
procedure  in  the  most  minute  degree.  The  tempta- 
tions of  public  positions  will  frequently  turn  honest 
men  into  dishonest  public  employes  unless  some  legal 
and  capable  check  is  placed  on  their  work. 

11.  The  accounting  foundation  in  budget  making, 
— A  proper  accounting  system  is  equally  important. 
If  the  legal  statutes  pertaining  to  a  budget  system 
cover  the  accounting  procedure,  so  much  the  better. 
A  comprehensive  accounting  system,  providing  com- 
plete information  regarding  the  detailed  operation  of 
every  department,  is  necessary.  Standard  accounts 
and  a  uniform  classification  of  expenditures  for  the 
various  departments  should  be  required.  The  rec- 
ords of  actual  expenditures  of  previous  periods 
should  be  available  for  comparison  with  the  estimated 
expenditure  for  subsequent  periods. 

12.  Statistical  methods  in  connection  with  budget 
reports. — In  municipal  transactions  the  personal  and 
financial  elements  are  of  equal  importance.  Personal 
service  records  of  all  employes,  with  detailed  informa- 
tion as  to  their  ability  and  past  records,  should  be 
kept.  Positions  should  be  standarized  and  classified 
by  competent  investigators.  It  is  not  easy  to  find  the 
right  type  of  men  to  do  this  work,  and  much  of  the 
criticism  that  has  been  leveled  at  bureaus  of  standards 
is  justified,  because  of  the  incapacity  of  those  who 
have  been  entrusted  with  this  work.     There  is  a  large 


298     FINANCIAL  AND  BUSINESS  STATEMENTS 

field  for  the  development  of  the  use  of  statistical  meth- 
ods in  connection  with  budget  reports.  Department 
heads,  in  submitting  their  departmental  estimates,  and 
the  budget  commissions,  in  presenting  a  complete 
budget  to  the  legislative  body  or  to  the  public, 
should  make  use  of  graphic  exhibits.  Important 
points  that  would  be  lost  in  the  maze  of  figures  will 
show  up  far  more  clearly  if  pictured  in  graphic  form. 
Unit  costs,  wherever  obtainable,  compared  with  the  re- 
sults of  previous  years,  will  often  be  interesting. 
Charts  of  the  intangible  results  obtained  from  the 
operations  of  various  departments  will  measure  to 
some  extent  the  efficiency  of  these  departments.  For 
instance,  the  exhibit  of  the  fire  department  might 
chart  the  number  of  fires  during  the  year,  the  amount 
of  fire  loss  for  each  year,  and  comparative  figures  with 
the  results  in  other  cities.  The  police  exhibit,  the 
health  exhibit,  etc.,  might  take  much  the  same  form. 
The  savings  made  in  operating  expenses,  thru  the  use 
of  modern  mechanical  aids  to  bookkeeping  and  record- 
ing, might  also  be  illustrated. 

13.  Budget  machinery. — We  have  seen  that  the 
first  step  is  to  have  estimates  from  department  heads 
and  to  require  that  these  estimates  be  properly  sup- 
ported by  explanatory  schedules  and  comparative 
statements  of  results  in  previous  years.  After  the 
departmental  estimates  have  been  turned  in,  an  inde- 
pendent investigation  should  be  conducted  by  the  bud- 
get commission  or  its  representatives ;  this  investiga- 
tion may  be  collateral  with  the  preparation  of  the  de- 


MUNICIPAL  BUDGETS  299 

partmental  estimates.  In  the  final  hearings  on  the 
budget,  publicity  is  a  prime  essential.  The  com- 
plaints or  suggestions  of  citizens  should  be  given  due 
consideration. 

After  receiving  reports  from  the  investigators  and 
hearing  the  public  criticisms,  the  commission  or  body 
charged  with  the  duty  of  preparing  the  budget  will 
set  the  maximum  limit  for  budget  appropriation. 
Departmental  heads  will  be  consulted  when  it  is  pro- 
posed to  reduce  any  budget  appropriation.  In  cer- 
tain cases,  the  hands  of  a  budget  commission  are  tied 
by  a  state  legislature  because  of  the  passage  of  special 
enabling  acts  or  mandatory  provisions.  The  budget 
is  then  usually  submitted  to  a  legislative  board,  which 
board  has  usually  the  power  to  reduce  but  not  to  in- 
crease the  appropriations. 

14.  Determining  the  tax  rate, — Notwithstanding 
popular  opinion,  city  officials  in  a  single  year  can  do 
very  little  toward  increasing  or  decreasing  the  tax 
rate.  Many  of  the  expenditures  are  fixed  in  amount 
and  cannot  be  affected  by  the  actions  of  the  city  offi- 
cials. For  instance,  interest  on  municipal  debts, 
sinking  fund  contributions,  and  the  municipality's 
share  of  the  state  or  county  taxes  are  entirely  out- 
side the  control  of  the  municipality.  On  the  other 
hand,  certain  expenditures  have  been  made  manda- 
tory by  state  legislatures,  and  many  others  are  semi- 
fixed because  of  their  very  nature. 

At  regular  intervals  during  the  fiscal  year,  reports 
should  be   published   showing  the   amounts   appro- 

XXII— 21 


300     FINANCIAL  AND  BUSINESS  STATEMENTS 

priated  for  the  use  of  the  various  departments,  the 
amount  expended  by  the  departments  to  date,  the 
commitments  against  any  appropriation  to  date  even 
tho  the  expenditure  has  not,  as  yet,  been  actually  paid 
in  cash,  and  finally,  the  unexpended  balance  of  the 
appropriation.  Whenever  work  schedules  form  part 
of  the  budget,  then  the  actual  results  accomplished 
should  be  set  off  against  the  work  schedules. 

15.  Transfers  and  changes  in  the  budget. — The 
budget  commission,  or  other  board,  having  power  to 
check  up  the  operation  of  the  budget,  should  also  have 
full  facilities  for  examining  into  details.  They  should 
be  empowered  to  approve  of  changes  in  policies  and 
able  to  increase  appropriations  where  necessary. 
They  should  also  authorize  the  transfer  of  funds 
when  such  a  step  is  advisable.  In  this  connection,  it 
would  be  well  to  state  that  any  transfer  of  funds  from 
one  appropriation  account  to  another  or  from  one 
department  to  another,  should  be  made  only  after 
the  relative  needs  of  each  department  or  each  func- 
tion have  been  carefully  examined. 

16.  Providing  in  the  budget  for  unforeseen  needs. 
— It  will  frequently  happen  that  estimates  at  the  be- 
ginning of  a  period  will  not  be  strictly  applicable  thru- 
out  the  period.  Unforeseen  needs  will  arise  in  con- 
nection with  some  function,  or,  certain  other  functions 
may  be  over-estimated;  for  example,  a  serious  epi- 
demic might  exhaust  the  funds  of  the  health  de- 
partment and  make  necessary  an  increase  in  the  ap- 
propriation.    The  accounting  records  will  show  all 


MUNICIPAL  BUDGETS  301 

the  surplus  funds  either  of  an  individual  department 
or  of  the  city  as  a  whole.  The  governing  board  hav- 
ing charge  of  the  preparation  of  the  budget  or  its 
operation,  should  have  power  to  re-allot  these  un- 
distributed portions  wherever  extra  or  unforeseen 
needs  arise. 

17.  Other  public  budgets. — Closely  related  to  the 
subject  of  municipal  budgets  is  the  use  of  budgets 
in  the  county,  state  and  federal  governments.  The 
conditions  here  are  so  different  from  those  in  cities 
that  the  need  of  budget  reform  has  not  been  so  notice- 
able. Indirect  taxation,  which  furnishes  most  of  the 
revenues  of  such  bodies,  is  not  felt  by  the  public  and 
is  not  a  subject  of  such  direct  importance  to  them. 
The  tendency  of  the  officials  of  such  governmental 
bodies  has  been  to  spend  the  amount  of  the  revenue 
received  rather  than  to  reduce  the  tax  rate,  because 
indirect  taxation  usually  brings  in  an  indefinite  and 
frequently  an  excessive  revenue.  The  budget  sys- 
tem, however,  is  just  as  essential  for  these  forms  of 
government  and  should  be  carried  out. 

18.  Some  fundamentals  in  budget  interpretation. 
— While  the  methods  followed  in  interpreting  budgets 
by  officials,  or  by  taxpayers,  will  vary  with  the  budget 
system  and  with  the  individual  conditions  of  each  lo- 
cality, the  reader  will  note  a  few  fundamental  points 
which  should  be  observed. 

The  interest  centers  quite  naturally  on  the  ex- 
penditure side  of  the  budget  more  than  upon  the  re- 
ceipt or  income  side.     Comparison  between  expenses 


302     FINANCIAL  AND  BUSINESS  STATEMENTS 

of  preceding  years,  the  appropriation  for  the  coming 
year  and  the  expenses  of  the  current  year  up  to  the 
date  of  the  report,  together  with  the  estimated  ex- 
penses for  the  rest  of  the  current  year,  and  the  de- 
partmental estimates  for  the  complete  year  should  be 
arranged  side  by  side.  Any  differences  in  these 
amounts  should  be  noted  and  changes  from  year  to 
year  should  be  watched.  For  example,  an  increase  in 
personal  services,  supplies  and  the  like,  or  a  decrease 
in  services  other  than  personal,  such  as  contract  serv- 
ices, would  indicate  that  more  of  the  city's  work  was 
being  done  by  its  own  employes  and  less  by  outside 
contracts. 

A  decrease  in  rentals  or  an  increase  in  property 
purchases  might  indicate  expenditures  for  permanent 
property  to  replace  leased  property.  A  marked  fall- 
ing off  in  the  maintenance  expenses  might  indicate 
that  the  property  and  equipment  were  not  being 
properly  kept  up.  Increased  expenditure  for  prop- 
erty acquisition  should  result  in  an  increased  main- 
tenance charge  in  succeeding  years.  If  this  does  not 
result,  then  the  property  is  not  being  maintained 
properly.  Increases  in  operating  expenses  may  be 
the  result  of  the  expansion  of  existing  functions,  the 
taking  on  of  new  functions  not  previously  performed, 
or  the  result  of  inefficiency  of  operation. 

The  relative  use  of  borrowed  moneys  for  current 
expenses  and  for  permanent  improvements  should  be 
clearly  indicated  in  the  comparison.     These  are  but 


MUNICIPAL  BUDGETS  303 

a  few  of  the  many  factors  for  which  one  examining 
a  municipal  budget,  must  watch.  They  afford,  how- 
ever, some  indication  of  the  manner  in  which  such 
statements  should  be  read. 

19.  Extending  the  scope  of  the  budget. — Where 
the  city  is  operating  a  municipal  gas  plant,  a  street 
railroad,  or  other  revenue-producing  property,  sep- 
arate and  detailed  operating  statements,  as  well  as 
balance  sheets  for  such  properties,  should  be  pre- 
pared. The  time  is  undoubtedly  coming  when  the 
taxpayers  will  receive  reports  of  municipal  operations 
disclosing  (1)  the  financial  condition  of  the  munici- 
pality, showing  its  permanent  assets  and  improve- 
ments, and  the  funded  debt  of  the  municipality,  (2) 
its  available  assets  in  liquid  form  and  its  outstanding 
obligations  and  commitments — both  of  these  state- 
ments to  be  prepared  in  comparative  form,  (3)  the 
separation  of  income  and  capital  receipts  and  pay- 
ments. 

When  these  reforms  have  been  carried  out,  the  pub- 
lic officers  of  a  municipality  will  be  able  to  justify 
their  administration.  The  taxpayers  and  the  admin- 
istrative officers  of  the  governmental  body  will  also 
have  information  upon  which  may  be  determined, 
first,  the  character  and  the  cost  of  the  services  ren- 
dered; second,  the  economy  or  waste  in  the  various 
departments;  third,  the  efficiency  or  inefficiency  of 
public  officials  and  employes;  fourth,  the  financial 
condition  of  the  municipality  at  any  stated  time ;  fifth, 


304     FINANCIAL  AND  BUSINESS  STATEMENTS 

a  just  apportionment  and  distribution  of  the  tax  levy 
among  the  various  departments  each  of  which  com- 
pete for  their  respective  allotments. 

The  taxpayer  will  know  whether  or  not  he  is  re- 
ceiving his  money's  worth  for  the  taxes  he  pays;  he 
will  know  that  his  public  officials  are  honest.  He 
will  know  that  proper  provision  is  being  made  for  in- 
terest and  amortization  of  the  city  debt,  and  he  will 
be  able  to  determine  in  his  own  mind  whether  or  not 
the  administration  is  "making  good." 

REVIEW 

What  is  the  fundamental  difference  between  a  private  and  a 
public  budget? 

What  part  does  borrowing  play  in  a  municipal  budget? 

Distinguish  between  a  segregated  and  lump  sum  budget  and 
state  the  advantages  and  disadvantages  of  each. 

Describe  the  process  of  preparing  a  municipal  budget. 

How  far  is  it  possible  for  city  officials  to  alter  the  tax  rate  ? 

What  information  is  to  be  sought  in  examining  a  municipal 
budget,  and  how  may  its  items  be  listed  as  to  their  reasonable- 
ness ? 


CHAPTER  XXII 

INTERPRETATION  OF  PROFESSIONAL  REPORTS 

1.  Criticism  due  to  improper  interpretation. — 
Much  of  the  unjust  criticism  that  has  been  directed 
against  accountants  and  appraisers  in  the  past  is  due 
to  the  fact  that  reports  prepared  by  them  have  not 
been  properly  interpreted  by  the  business  man.  On 
the  other  hand,  just  criticism  must  be  given  to  those 
professional  men  who  issue  reports  that  are  so  ob- 
scurely phrased  or  vaguely  worded  as  to  make  it  al- 
most impossible  to  determine  the  conclusions  of  the 
writer.  Moreover,  business  men  and  the  general  pub- 
lic need  to  be  informed  of  the  technical  meaning  of 
certain  terms  and  phrases  which,  thru  long  continued 
custom,  have  acquired  a  definite  meaning  or  special 
significance  in  the  business  profession. 

2.  Interpretation  of  an  auditor's  certificate. — In 
the  Text  on  "Accounting  Practice  and  Auditing"  the 
reader  will  have  noted  two  common  forms  of  certifi- 
cates attached  to  the  reports  of  auditors.  A  certifi- 
cate may  vary  from  the  simple  phrase,  "Audited  and 
found  correct"  to  the  very  elaborate  form  of  certifi- 
cate which  states  minutely  the  responsibility  which 
the  auditor  assumes  for  the  valuation  and  verification 
of  the  principal  classes  of  assets.     Therefore,  in  read- 

305 


306     FINANCIAL  AND  BUSINESS  STATEMENTS 

ing  a  report  submitted  by  an  auditor,  attention  should 
first  be  directed  to  the  form  of  certificate  attached. 
Qualifications,  if  any,  should  be  particularly  noted. 

Thus,  the  certificate  of  an  auditor  which  states  that 
the  books  have  been  audited  and  that  amounts  shown 
in  the  balance  sheet  are  in  agreement  with  the  values 
stated  in  the  ledger,  means  that  the  auditor  certifies 
to  the  fact  that  the  balance  sheet  agrees  mathemati- 
cally with  the  figures  found  in  the  ledger  of  the  busi- 
ness whose  accounts  have  been  audited. 

From  the  business  man's  viewpoint,  such  a  cer- 
tificate has  little  value  for  the  reason  that  no  re- 
sponsibility is  assumed  by  the  professional  auditor 
except  as  to  mathematical  agreement.  Assets  may 
be  grossly  overvalued  and  liabilities  may  be  under- 
stated in  the  books  without  disclosure.  A  creditor  or 
an  investor,  noting  that  the  certificate  was  signed  by 
a  licensed  auditor,  seeing  also  that  the  books  have 
been  "audited"  and  that  the  statement  put  forth  by 
the  firm  agrees  with  its  books,  might  be  deceived  to 
his  detriment  into  believing  that  such  a  certificate 
guaranteed  the  financial  condition  of  the  firm. 

3.  Certification  as  to  values  of  real  property  and 
fixed  assets. — The  reader  has  already  learned  that  an 
auditor  is  not  a  valuer  or  an  insurer.  With  what 
measure  of  confidence  can  we  regard  the  certificate  of 
the  auditor  as  to  the  value  assigned  to  fixed  assets 
in  a  certified  balance  sheet?  It  is  to  be  presumed 
that,  if  an  unqualified  certificate  has  been  given  in  re- 
spect of  the  fixed  assets,  the  auditor  has  either  sup- 


PROFESSIONAL  REPORTS  307 

ported  the  valuation  by  having  an  appraisal  prepared 
by  competent  appraisers  or  is  satisfied  in  some  other 
way  as  to  the  valuation.  There  is  no  doubt  but  that 
an  experienced  auditor  is  able  to  certify  satisfactorily 
to  the  approximate  value  of  fixed  property  in  many 
cases.  At  least,  he  is  competent  to  express  an  opinion 
as  to  the  adequacy  of  the  provision  for  depreciation. 
But,  on  the  other  hand,  his  limited  ability  in  the  field 
must  be  clearly  recognized  by  the  reader  of  his  cer- 
tificate. 

If  the  certificate  states  that  the  values  assigned  to 
the  fixed  assets  appear  to  be  conservative  and  no 
mention  is  made  of  an  appraisal,  the  reader  must  un- 
derstand that  the  auditor  has  merely  exercised  his 
best  judgment  and  discretion  in  agreeing  to  the  val- 
uation. Whatever  weight  is  to  be  given  to  his  opinion 
in  the  matter  the  reader,  having  regard  to  the  qualifi- 
cation and  experience  of  the  auditor,  must  determine. 

It  should  be  noted  that  an  expression  of  opinion 
relative  to  the  adequacy  or  inefficiency  of  the  pro- 
vision for  depreciation  is  tantamount  to  a  certification 
of  the  valuation  of  the  property. 

4.  Certifying  to  the  valuation  of  inventories, — One 
who  reads  a  professional  report  should  pay  particular 
attention  to  the  certificate  of  the  auditor  in  respect  of 
the  inventories  of  raw  material,  work  in  progress  and 
finished  goods. 

As  a  rule,  the  auditor  will  not  be  present  when  the 
inventory  is  taken,  and  the  character  of  the  mer- 
chandise stocks  may  have  changed  to  a  considerable 


308     FINANCIAL  AND  BUSINESS  STATEMENTS 

extent  between  the  time  when  the  inventories  were 
taken  and  the  date  of  the  auditor's  investigation. 
Thus,  an  auditor  is  often  obliged  to  accept  the  valua- 
tion placed  upon  inventories  submitted  to  him  by  the 
managers.  Not  only  has  he  to  accept  the  certifica- 
tion of  the  management  as  to  quantities,  but  often  as 
to  prices. 

However,  even  tho  the  auditor  accepts  the  valua- 
tion and  the  quantities  reported  by  the  management 
and  so  states  in  his  certificate,  he  is  not  relieved  from 
the  responsibility  of  assuring  himself  that  the  persons 
who  took  the  stock  were  competent  to  do  so  and  that 
they  fully  appreciated  the  importance  of  their  re- 
sponsibility. He  will,  as  a  rule,  make  some  investiga- 
tion into  the  accuracy  of  the  method  and  system  em- 
ployed in  ascertaining  the  value,  and  the  correctness 
of  the  pricing  and  of  the  mathematical  work  so  as  to 
satisfy  himself  that  the  results  are  worthy  of  accept- 
ance. 

5.  Procedure  where  inventories  may  not  be  relied 
upon. — Where  the  inventories  have  been  taken  by  per- 
sons incompetent  to  do  so;  by  those  on  whose  judg- 
ment the  auditor  does  not  rely;  or  where,  by  reason 
of  other  circumstances,  the  auditor  may  not  feel  justi- 
fied in  accepting  the  statements  handed  to  him,  he 
will  state  in  his  certificate  that  the  inventory  has  been 
entered  at  the  values  assigned  to  it,  subject  to  what- 
ever qualification  he  deems  it  necessary  to  append. 
The  use  of  the  phrase  "subject  to"  implies  that  the 
auditor  himself  is  not  willing  to  assume  the  respon- 


PROFESSIONAL  REPORTS  309 

sibility  for  the  quantities  or  the  valuation  and  one  who 
reads  the  report  must  be  governed  accordingly.  In 
some  instances  the  auditor  will  certify  as  to  the  ac- 
curacy of  the  extensions  and  footings  and  thus  assume 
responsibility  solely  for  this  part  of  the  inventory. 

6.  An  auditor  is  not  entirely  absolved  by  qualifica- 
tions from  responsibility. — Even  here  the  auditor  is 
not  absolved  from  all  responsibility  for,  if  anything 
arises  during  the  course  of  his  investigation  which 
would  lead  him  to  believe  that  the  officers  were  at- 
tempting to  commit  fraud  in  respect  of  the  inventory 
or  any  other  asset,  it  is  clearly  his  duty  to  decline  to 
give  even  a  qualified  certificate.  Inasmuch  as  an 
auditor  cannot  control  the  use  of  his  report  after  it 
leaves  his  hands,  it  is  questionable  whether  or  not  he 
has  relieved  himself  of  his  moral  responsibility  even 
tho  he  may  have  absolved  himself  from  all  legal  re- 
sponsibility by  adroitly  wording  his  qualifying  cer- 
tificate. An  auditor  should  certainly  refuse  his  cer- 
tificate in  cases  where  fraud  has  been  attempted  by 
the  management.  For  this  reason  that  while  the  firm 
may  agree  to  re-state  values  in  those  cases  in  which 
the  auditor  has  discovered  inflation,  he  cannot  always 
be  able  to  ferret  out  all  ingeniously  laid  schemes  of 
fraud  and  he  may  thus  pass  over  other  frauds. 

7.  Examples  of  attempted  fraud. — Not  long  ago, 
in  the  city  of  New  York,  the  management  of  an 
American  branch  of  a  European  concern  was  sued 
by  a  salesman  for  breach  of  contract.  The  verdict  of 
^he  court  was  in  favor  of  the  salesman  and  judgment 


310     FINANCIAL  AND  BUSINESS  STATEMENTS 

was  given  to  the  amount  of  $13,000.  The  local  man- 
agement paid  the  amount  of  the  damages  but  charged 
the  amount  thereof  to  a  personal  account  in  the  name 
of  the  salesman.  In  the  trial  balance  submitted  each 
month  to  the  European  headquarters,  the  amount  paid 
out  was  reported  as  an  account  receivable.  A  firm  of 
auditors,  upon  being  called  to  investigate,  were  re- 
quested to  certify  to  the  balance  sheet  and  when  this 
item  was  discovered  very  properly  declined  to  give 
a  certificate.  It  subsequently  developed  that  the 
management  of  the  branch  had  also  grossly  over- 
valued the  inventory  thereby  concealing  operating 
losses  in  the  year  under  investigation  amounting  to 
$178,000. 

In  one  of  the  recent  consolidations  underwritten  by 
a  firm  of  Eastern  bankers,  a  firm  of  auditors  was  in- 
trusted with  the  duty  of  preparing  balance  sheets  of 
the  various  concerns  to  be  amalgamated  for  the  pur- 
pose of  determining  the  basis  upon  which  each  con- 
cern was  to  be  taken  into  the  consolidation.  While 
auditing  the  accounts  of  one  of  the  concerns,  the  firm 
of  auditors  was  obliged  to  transfer  the  principal  in 
charge  of  the  engagement  to  another  station  and  his 
successor  accepted  the  valuation  of  the  inventory 
without  sufficient  investigation.  When  the  consolida- 
tion finally  took  place,  inventory  values  to  the  ex- 
tent of  $1,000,000  could  not  be  located  and  the 
bankers  underwriting  the  consolidation  were  com- 
pelled to  put  into  the  business  an  equivalent  amount 
of  cash  to  protect  their  own  reputation  as  well  as  to 


PROFESSIONAL  REPORTS  311 

protect  clients  who  purchased  securities  upon  their 
solicitation. 

8.  Auditor  s  report  regarding  statement  of  re- 
sponsibility as  to  trade  debts. — If  the  report  of  the 
auditor  contains  an  unqualified  certificate  in  respect 
of  the  amount  due  from  customers  both  on  open  ac- 
counts and  notes,  it  may  be  assumed  that  not  only  has 
the  auditor  verified  the  amount,  but  that  he  has  made 
adequate  provision  for  all  doubtful  debts.  Absolute 
verification  of  the  amount  due  can  only  be  obtained 
from  the  debtor,  thru  the  medium  of  confirmation 
statements.  In  many  instances,  clients  object  to  this 
practice  of  obtaining  confirmation  statements  from 
their  customers,  under  which  circumstances  the  audi- 
tor cannot  give  an  unqualified  certificate.  In  these 
cases,  other  methods  of  verification  are  open  to  him. 
In  the  absence  of  any  suspicious  circumstances  the 
auditor  is  justified  in  accepting  the  amount  as  stated 
in  the  ledger  account.  He  will  probably  certify  to 
the  fact  that,  having  made  a  test  of  the  "accounts  re- 
ceivable" and  having  reconciled  the  customers'  ledgers 
with  the  respective  controlling  accounts,  they  appear 
to  be  properly  stated.  He  will  also  probably  com- 
ment upon  the  sufficiency  of  the  provision  for  doubt- 
ful debts. 

9.  Interpretation  of  phrase  ff  properly  drawn  up." 
— The  certificate  of  the  auditor  implies  also  that  the 
balance  sheet  which  he  prepares  has  been  drawn  up 
in  such  a  manner  as  to  exhibit  truthfully  the  financial 
condition  of  the  undertaking.     The  term  "drawn  up" 


312     FINANCIAL  AND  BUSINESS  STATEMENTS 

implies  that  the  amounts  due  from  trade  debtors  are 
not  to  be  merged  with  the  amounts  due  for  the  loans 
made  to  officers  or  stockholders  of  the  undertaking 
or  to  partners.  It  does  not  include  amounts  due  from 
stockholders  on  unpaid  subscriptions  to  the  capital 
stock  of  the  undertaking. 

Thus,  the  term  "accounts  receivable,"  while  ordi- 
narily a  broader  term  than  that  of  ''trade  debtors"  or 
"customers'  accounts"  should  include  under  it  only 
those  amounts  due  from  trade  debtors. 

10.  Omission  to  furnish  auditor  s  certificate  in  pub- 
lished report. — The  reader  has  undoubtedly  noted 
statements  in  a  prospectus  or  in  the  report  of  a  com- 
pany to  the  effect  that  the  accounts  of  a  company  have 
been  audited  by  Messrs.  Blank  and  Company,  Certi- 
fied Public  Accountants.  The  mere  statement,  unac- 
companied by  a  publication  of  the  auditor's  certificate, 
that  the  accounts  of  a  company  have  been  audited, 
should  be  viewed  with  suspicion.  The  auditors  may 
have  made  all  manner  of  qualifications  in  their  report 
of  which  the  stockholders,  investors  or  creditors  would 
be  ignorant  unless  they  adopted  the  rather  unusual 
step  of  demanding  a  copy  of  the  report. 

A  dishonest  board  of  directors  may  put  forth  a  bal- 
ance sheet  which,  while  purposely  misleading  may  be 
issued  in  such  a  manner  as  to  prevent  the  directors' 
indictment  for  fraud;  at  the  same  time  the  statement 
may  be  made  that  the  accounts  of  the  company  have 
been  audited  by  reliable  accountants.     The  layman, 


PROFESSIONAL  REPORTS  313 

in  the  majority  of  cases,  would  be  deceived  by  this 
practice. 

11.  M eagerness  of  information  in  published  re- 
ports.— Criticism  is  sometimes  heard  of  the  meager- 
ness  of  information  disclosed  in  published  reports  of 
auditors.  It  must  be  borne  in  mind  that  published  re- 
ports should  not  disclose,  concerning  the  affairs  of  an 
undertaking,  such  information  as  would  be  to  the  ad- 
vantage of  competitors.  Even  tho  the  report  may  be 
meager  in  respect  of  the  information  disclosed,  the 
stockholders  may  be  reassured  if  the  published  bal- 
ance sheet  is  that  of  a  reliable  firm  of  auditors  and  if 
a  favorable  or  unqualified  certificate  of  the  auditor  is 
attached.  The  auditors  can  be  depended  upon  to  pre- 
pare such  statements  as  the  stockholders  ought  to 
have  but  which,  at  the  same  time,  will  not  disclose 
information  of  vital  importance  to  competitors. 
Hence,  it  is,  that  stockholders  or  creditors  should  con- 
sider seriously  the  nature  of  the  auditor's  certificate 
where  the  published  report  fails  to  give  sufficient  in- 
formation as  will  enable  one  to  analyze  the  financial 
condition  of  the  undertaking. 

12.  Certificate  of  profit. — Not  infrequently  one 
finds  in  a  prospectus  issued  to  aid  in  the  sale  of  se- 
curities, a  statement  to  the  effect  that,  based  upon  a 
report  prepared  by  Messrs.  Blank  and  Company, 
auditors,  the  profit  will  be  sufficient  to  provide  for 
twice  the  amount  necessary  to  meet  interest  on  bonded 
debt  and  sinking  fund  charges. 


314     FINANCIAL  AND  BUSINESS  STATEMENTS 

The  reader  must  bear  in  mind  that  Messrs.  Blank 
and  Company,  the  auditors,  may  not  have  made  this 
unqualified  statement,  but  the  promoters  or  managers 
of  the  undertaking  may  have  drawn  a  conclusion  from 
a  certificate  of  profit  or  a  report  prepared  by  the 
auditors.  It  is  doubtful  if  any  reliable  firm  of  audi- 
tors would  permit  their  own  certificate  of  profit  to  be 
used  for  such  speculative  prediction.  Auditors  are 
justified,  however,  in  preparing  a  report  for  the  pro- 
moter or  manager;  the  latter  assumes  all  responsi- 
bility for  the  conclusions  which  are  drawn  from 
such  a  report.  The  investor  must  clearly  understand 
that  the  auditors  are  not  certifying  to  the  profit  to  be 
realized  in  the  future. 

In  preparing  a  statement  of  profits,  an  auditor  is 
justified  in  ek'minating  certain  items  which  may  ap- 
pear in  the  profit-and-loss  account  of  an  undertaking. 
In  the  first  place,  he  may  eliminate  all  sums  paid  for 
borrowed  funds,  on  the  theory  that  the  concern  in- 
tends to  raise  an  amount  of  owned  capital  sufficient  in 
amount  to  avoid  the  necessity  of  borrowing  money. 
The  sum  paid  for  interest  on  borrowed  capital  is  a 
penalty  for  not  having  a  sufficient  amount  of  owned 
capital  in  the  business.  Furthermore,  the  auditors 
may,  for  the  benefit  of  the  promoter,  estimate  the  sav- 
ings to  be  anticipated  as  a  result  of  combination  thru 
the  consolidation  of  selling  activities  and  the  elimina- 
tion of  a  great  deal  of  the  administrative  expense.  It 
has  often  happened,  however,  that  these  anticipated 
economies  have  not  been  realized  and  good-will  based 


PROFESSIONAL  REPORTS  315 

upon  the  anticipated  saving  in  many  instances  has 
been  greatly  over-valued. 

13.  Reports  of  appraisers. — From  time  to  time,  the 
necessity  has  arisen,  from  one  cause  or  another,  of 
determining  the  present-day  value  of  mercantile  prop- 
erty. The  great  variety  of  property  to  be  valued  has 
resulted  in  the  creation  of  several  large  appraisal  com- 
panies who  have  gathered  together  a  force  of  expe- 
rienced engineers  and  valuers.  These  companies 
render  a  valuable  service  to  the  business  community, 
and  business  undertakings  are  beginning  to  appre- 
ciate the  value  of  the  service  rendered. 

The  reader  has  already  seen  that  the  problem  of 
depreciation  is  one  of  the  most  difficult  which  account- 
ants and  business  men  are  called  upon  to  face.  In 
order  that  it  may  be  known  whether  or  not  proper 
provision  is  being  made  for  depreciation,  it  is  neces- 
sary to  confirm  by  an  appraisal  the  adequacy  of  the 
rates  that  are  being  used  in  depreciating  the  fixed  as- 
sets of  a  business  undertaking. 

In  public  utilities  the  question  of  a  fair  rate  of 
return  on  the  investment  necessitates  an  appraisal  of 
the  fixed  property  used  in  rendering  the  service  to 
the  community  for  the  purpose  of  determining  the 
principal  sum  upon  which  the  rate  of  return  is  to  be 
calculated. 

The  capital  accounts  of  other  business  undertakings 
may  have  been  kept  in  a  haphazard  manner  and  the 
clear  differentiation  between  revenue  and  capital 
charges  may  not  always  have  been  observed.     Hence 

XXII— 22 


316     FINANCIAL  AND  BUSINESS  STATEMENTS 

the  necessity  of  determining  the  actual  value  of  the 
investment  in  fixed  assets  by  means  of  a  disinter- 
ested appraisal. 

The  purchaser  of  a  business  would  be  very  unwise 
to  take  for  granted  that  the  book  value  of  the  physi- 
cal assets,  subject  to  depreciation,  was  the  actual  value 
and  in  purchasing  property  of  this  character,  the  cost 
of  an  appraisal  may  be  regarded  as  a  very  cheap  form 
of  insurance. 

Business  men  who  may,  perhaps,  have  had  an  un- 
satisfactory experience  with  insurance  adjusters  at 
the  time  of  a  fire  loss  realize  the  comparative  ease  with 
which  their  claims  for  loss  may  be  proved  if  such 
claims  are  supported  by  a  disinterested  appraisal  of 
competent  valuers. 

14.  Basis  of  valuation. — Appraisal  companies  gen- 
erally attempt  to  determine  the  value  of  physical  as- 
sets at  the  cost  of  reproduction  under  present  day 
prices  for  material  and  labor  after  deducting  the  fair 
amount  for  depreciation  sustained  since  the  acquisi- 
tion of  the  asset.  In  addition,  the  appraisers  will 
usually  indicate  the  insurable  value  which  is  the  cost 
of  reproduction  less  physical  depreciation  with  a  fur- 
ther deduction  for  the  value  of  that  portion  of  the 
physical  assets  which  is  not  the  subject  matter  of  in- 
surance, such  as  foundations  and  excavations  and  sub- 
soil structures.  Provision  is  made  for  keeping  the 
appraisal  up  to  date  by  furnishing  the  company  with 
a  list  of  all  after-acquired  assets,  and  re-appraisals 
are  usually  made  at  periodic  intervals. 


PROFESSIONAL  REPORTS  317 

15.  Adjustment  of  book  values  to  appraisal  values. 
— If  the  appraisal  of  property  discloses  that  the  value 
of  any  unit  is  less  than  the  cost  value  as  reduced  by 
the  accrued  depreciation  thereof,  the  book  value  should 
be  adjusted  to  the  appraised  value.  If  the  appraised 
value  discloses  the  fact  that  the  present-day  value, 
at  the  cost  of  reproduction,  is  in  excess  of  the  cost  less 
accrued  depreciation,  it  would  not  be  conservative 
practice  to  adjust  the  book  value  to  the  increased  ap- 
praised value.  It  is  not  considered  good  practice  to 
swell  surplus  accounts  in  this  manner.  It  would  be 
better  to  reduce  the  rate  of  depreciation  in  subsequent 
periods  as  the  higher  value  indicates  that  excessive 
depreciation  is  being  provided  for. 

In  this  connection,  however,  consideration  must  be 
given  to  the  fact  that  appraisers  are  generally  in- 
fluenced in  their  consideration  of  value  by  the  present- 
day  costs  of  raw  material  and  labor.  These  may  be 
higher  or  lower  than  the  respective  costs  at  the  time 
the  assets  were  acquired.  As  has  been  stated,  the  ac- 
countants support  the  cost  theory  of  value  rather  than 
the  theory  of  cost  of  reproduction.  The  results 
shown  by  the  appraisal  should,  as  a  general  rule,  be 
used  only  to  correct  the  values  of  assets  which  ap- 
pear to  be  over-stated  but  should  not  be  used  to  change 
the  value  of  assets  which  appear  to  be  under-stated. 

The  appraisal  also  serves  to  justify  the  values  en- 
tered for  fixed  assets  in  a  proof  of  claim  in  fire  losses 
for  a  contract  of  insurance  is  a  contract  of  indemnity 
and  the  insured  is  entitled  to  recover  from  the  in- 


318     FINANCIAL  AND  BUSINESS  STATEMENTS 

surer  the  value  of  the  property  destroyed  at  the  time 
of  fire. 

16.  Reports  of  engineers. — The  reader  may  be 
called  upon  to  base  his  executive  judgment  upon  the 
report  of  an  engineer  and  the  same  care  should  be  used 
in  the  interpretation  of  a  report  of  this  character  as 
is  used  in  interpreting  the  report  of  an  auditor.  The 
value  of  the  report  of  an  engineer  depends,  in  large 
measure,  upon  his  experience.  In  the  majority  of 
cases,  his  conclusions  are  subject  to  adjustment  be- 
cause of  the  greater  number  of  variables  involved. 
This  is  especially  true  of  mining  engineering.  An 
engineer's  report  should  be  prepared  in  collaboration 
with  that  of  a  competent  geologist. 

Another  important  point  to  be  borne  in  mind  is 
that  the  report  of  the  auditor  usually  deals  with  con- 
clusions based  upon  known  facts  of  past  experience. 
The  engineer  is  called  upon  to  deal  with  problems 
more  or  less  speculative  in  their  nature.  Therefore, 
there  is  more  necessity  on  the  latter's  part  for  extreme 
caution  in  interpreting  facts  and  determining  future 
results.  A  liberal  allowance  for  possible  error  on  the 
engineer's  estimates  of  costs  should  be  provided  for; 
it  is  a  well-known  fact  that  many  engineers  have  an 
inadequate  conception  of  costs  and  accounts. 

17.  Conclusion. — The  value  of  any  report  depends 
primarily  upon  the  factors  of  the  experience,  judg- 
ment and  integrity  of  the  professional  man  who  ren- 
ders it.     Conclusions  based  upon  proven  facts  should 


PROFESSIONAL  REPORTS  319 

be  clearly  distinguished  from  opinions  based  upon 
speculative  deductions. 

REVIEW 

What  may  the  auditor's  certificate  contain,  and  why  should 
its  wording,  its  contents  and  omission  be  carefully  scrutinized? 

What  responsibility  may  an  auditor  properly  assume  as  re- 
spects inventories  and  accounts  receivable? 

Meet  the  objection  that  the  auditors'  published  reports  usually 
give  scanty  information.  Should  an  auditor  certify  to  probable 
profit  and  if  so  under  what  conditions? 

What  is  the  function  of  appraisal  companies? 


INDEX 


Accountant,  the,  and  the  Law,  87 

Accounting  Practice  at  Variance  with 
the  Law,   88 

"Accounting  Practice  and  Auditing," 
53,    305 

Accounting,    Principles   of,    Fixed   un- 
der all   conditions,   83 

Accounting    Systems,    Impracticability 
of   single  type,    7 

Accounts,    Expense,    See   Expense   Ac- 
counts 

Accounts   Receivable, 

Schedule  of,  36-37;  In  auditor's 
certificate,    311 

Acquired      Companies,      Methods      of 
treating  surplus  accounts  of,   255 

Additions,   Of  buildings,   110 

Administrative   Expenses,    73 

Advertising  Expense, 

Items  included  in,  70-71;  Treat- 
ment in  balance   sheet,   71 

Analyses,    Sales,    39-40 

Analysis    and    Interpretation    of    In- 
come Statements,  48-68,  69 

Analytical  Expense    Statements,    19 

Annuity,     In     connection     with     lease, 
105 

Appraisal,   And  revaluation,   204 

Appraiser's   Report, 

Depreciation  allowance,  315—16; 
Necessity  for,  315;  Basis  of 
valuation,  316-17;  Book  value 
of  assets,  316;  Cheap  form  of 
insurance,  316;  Cost  of  raw  ma- 
terial and  labor,  316-17;  Keep- 
ing up  to  date,  316;  Value  in 
fire  loss,  316-18;  Adjustment  of 
book  and  appraisal  values,  317- 
18;  Cost  theory  of  valuation,  317; 
Fixed    assets,    317-18 

Appreciation,   Of  land,    107 

Assets, 

Current,  and  current  liabilities, 
189;  And  surplus,  196;  Fixed, 
surplus  from  sale  of,  201-03; 
Total  invested,  relation  of  net 
income  to,  228-29;  Invested, 
ratios  based  on,  proper  for  com- 
parison, 229;  And  working  capi- 
tal, 230-31;  Quick,  amount  re- 
quired by  corporations,  232 


Assets — continued 

See    Current    Assets,    Fixed    Assets, 
Intangible  Assets 

Assets,  Capital,   See  Fixed  Assets 

Auditor,    Certificate   of, 

Two     forms     of,     305-06;     Balance 
sheet,    306;    Confidence    in,    306- 
07;    No   guarantee  as   to  financial 
responsibility,     306;     Real     prop 
erty,   306;   Valuation  of  fixed  as 
sets,      306-07;      Value,      306-07 
Inventories    as    valued    in,     307— 
08 ;     If    inventory     is    unreliable 
308;     Possible     qualifications     of 
308-09;    Responsibility   for,    308 
In    cases    of    fraud,    309-11;    In 
flated    value,    cause    for    refusing 
309;    When   to   be   declined,    309- 
11;  Confirmation  statements,  311 
Methods    of    verification    of    trade 
debts,  311;   "Properly  drawn  up,' 
311-12;   Trade  debts,  311;   Omis 
sion   of,    312-13;    Careful   consid 
eration  should  be  given  nature  of 
313 

Auditor,   Certificate  of  profit  of, 
Not      for      speculative      predictions, 
313-15;    Responsibility    for    con- 
clusions   drawn    from,     314 

Auditor,  Report  of,   See  Auditor,   Cer- 
tificate  of 

Auditor,  Responsibility  for  Certificate, 
308-09 

Auxiliary  Statements,  36 


Balance  Sheet, 

Principal  financial  statement,  4;  Of 
holding  company,  87;  Should 
show  financial  condition,  87; 
Combined,  90;  Consolidated,  90; 
Of  subsidiaries.  95;  Special  fac- 
tors in  interpretation  of,  114— 
16;  Good-will,  133;  And  contin- 
gent liabilities,  188;  Contingent 
assets,  consolidated,  230—37; 
Consolidated  and  par  value  of 
stock,  250;  "Properly  drawn 
up,"  311-12;  Auditor's  certifi- 
cate, 306;  May  be  purposely  mis- 
leading,   312-13 


321 


322 


INDEX 


Bankers,   Investments  of,   143-44 

Bauer,  John,  On  good-will,  131 

Betterments  of  Buildings,   110 

Bonds, 

Mining  companies,  105;  Discounts 
allowed  on  issue  of,  167—68; 
Methods  of  disposing  of  bond  dis- 
count, 168-69;  Premiums, 
170 
See   Investment 

Bondholders,  And  relation  between 
current  assets  and  current  lia- 
bilities,   189 

Book  Value, 

Not  always  actual  value,  317;  Ad- 
justment to  appraisal  value,  317— 
18 

Brokers,   Investments   of,    143-44 

Budget, 

Purpose  and  definition  of,  273;  An- 
nual, 273-74;  Production  and, 
279-80 

Budgets,  County,  State  and  Federal, 
301 

Budgets,   Municipal, 

Development,  289;  Differentiated 
as  compared  to  private,  289-90; 
Definition,  290;  Taxpayers  and 
the,  290;  And  the  department 
head,  290-91;  Function,  291- 
92;  Old-time,  292-93;  Modern, 
293;  Segregated,  293-94;  Lump 
sum,  its  advantages  and  disad- 
vantages, 294—95;  Lump  sum,  a 
variation  of,  295;  Essentials  in 
preparation,  295-96;  Necessary 
legal  foundation,  296-97;  Ac- 
counting and  statistics  in  rela- 
tion to,  297-98;  Machinery  of, 
298-99;  Tax  rate  and  the,  299- 
300;  Transfers  and  changes  in, 
300;  Unforeseen  needs,  300-01; 
Interpretation,  301-03;  Scope, 
303-04 

Budgets,    Private, 

Regular,  or  general  and  depart- 
mental, 273-75;  Purpose  of  spe- 
cial, 274;  Subdivision,  276;  Pre- 
requisites, 276-77;  Routine  con- 
nected with,  277;  Sales  depart- 
ment, 278;  Based  on  experience, 
278;  On  four-week  basis,  278- 
79;  Production  department,  279- 
80;  Assembling  data,  280-82; 
Considerations  affecting,  281, 
284-85;  Four  factors,  281; 
Accounting  records,  282;  Finan- 
cial guides,  283 ;  Interim  check 
on,  283-84;  Checking  data  as- 
sembled   in,    282 ;    Income    state- 


Budgets,   Private — continued 

ment,    285 ;    Departmental,    stand- 
ards for,   286 

Buildings, 

Distinct  from  land,  100-01;  Cost 
of  construction,  107-8;  Valua- 
tion, 107-08;  Two  theories  for 
loss  from  demolition,  109;  Ad- 
ditions, betterments,  repairs,  re- 
placements,   renewals,    110 

Business,  Division  of  Profitable,   92 

Business   Organization,   Effect   of   out- 
side factors  on,  3 

Business  Statistics, 

Meaning,  13;  Purpose  and  scope, 
13—14;  Distinguished  from  gov- 
ernment, 14;  Contents,  15-16; 
Uses,    16 

By-Products,     Separate     account     for 
sales  of,   52-53 


Capital, 

Effect  of  charging  items  to  revenue 
account,  76;  Impairment,  80; 
Dividends  out  of,  87,  93;  Rev- 
enue expenditure  distinguished, 
196-97;  Expenditures  charged 
against  surplus,  214-15;  Bor- 
rowed, in  auditor's  certificate, 
314;  Differentiation  from  rev- 
enue, 315—16 
See  Working  Capital 

Capital  Assets,  See  Fixed  Assets 

Capital   Stock, 

Discount  on  sale  of,  166;  Relation 
of   net   income   to,   226-28 

Capitalization, 

Of  carrying  charges  on  land  invest- 
ments, 102;  Of  land  improve- 
ments, 103 ;  Furniture  and  fix- 
tures,  112 

Capitalized  Surplus, 

Nature,  254;  Various  phases,  255- 
57 ;  Liquidation  of  investment, 
256;  Of  holding  companies,  four 
kinds  of,  255;  When  set  under 
separate  headings,  257;  Subsid- 
iary company,  257;  Illustrations 
of,    257-58 

Cash  in  Bank,   What  may  be  consid- 
ered as,   139 

Cash   on    Hand,    Definition,    139 

Cash  Report,   Contents  of,   41 

Certificate    of    Auditor,    See    Auditor, 
Certificate    of 

Charges,    Transportation,    Element    of 
cost,    60 

Classified  Information, 

Importance,   1;   Need  for,   1;   Meas- 


INDEX 


323 


Classified    Information — continued 

ure  of  efficiency,  2;   In  determin- 
ing   business    policies,    2;     Influ- 
ence on  legislation,  11 
Combined  Balance  Sheet,  90 
Companies,        Parent,        distinguished 
from    holding,    83-84 
See   Holding   Company- 
Company  Reports, 

Often     meager     information,      313; 

Omission   of    auditor's   certificate, 

312;     Misleading    balance     sheet, 

312;   Certificate  of  profit,   313-14 

Comparisons, 

Statistical,  22;  Establishing  stand- 
ards of,  25-26;  Value,  41-42; 
Of  sales  and  inventory,  57-58; 
Ratios  based  on  invested  assets 
should  be  used  for,  229;  Of 
actual  results  and  costs  with  pre- 
determined results  and  costs, 
274 
Confirmation  Statements,  311 
Consolidated  Balance  Sheet,   90,   237- 

38,    268-69 
Consolidated  Gas  Company,   123 
Consolidated  Statements, 

What  they  show,  90;  Necessary  to 
disclose  certain  factors,  92;  Dif- 
ferent from  consolidation  of  state- 
ments, 91;  Possible  legal  basis 
for,  238-39;  Individual  com- 
panies, 259;  Overcoming  disad- 
vantages of,  260;  Interpreta- 
tion, 260-61;  Individual  income 
statements,  261;  Various  forms, 
263-72;  Of  income  and  profit  and 
loss,  265-72 
Consolidation, 

Good-will,     132;     Advantages,     237; 
Consolidated   balance   sheet,   237- 
38 
Construction,  Inter-company  profits  on, 

98 
Containers,   Not   credited   to   sales   ac- 
count,   56—57 
Copyrights,    Valuation,    134-37 
Corporation      Stock      and      Treasury 

Stock,   173-74 
Corporations, 

Subsidiary,  84;  Profits  distributed 
only  by  board  of  directors,  86; 
Profits,  130-31;  Insurance  funds, 
224;  Quick  assets  required  by, 
231-32 
Cost, 

Definition,  59;  Distinguished  from 
expense,  59;  Elements  of,  60-61; 
Of  goods  sold,  64-65;  Of  manu- 
facture   distinguished    from    cost 


Cost — continued 

of  sales,  64-65;  Land  improve- 
ments, 103;  Building  construc- 
tion, 107-08;  England:  Dividends 
on  construction,  109 ;  Interest  on 
construction,  109;  Depreciation 
as  element  of,  197-98;  Income 
confused,  235-36;  Carrying  in- 
vestment at  original,  239 ;  Rec- 
ords, prerequisite  of  budget, 
276-77;  Interim  reconciliation  of 
estimate  with,  274;  Comparison 
of  actual,  with  predetermined,  in 
final  statement,  274 
Cost-Finding,  59,  64,  69-70 
Credit, 

Disposition     of     donation     reserve, 
175;    Risk    viewpoint    concerning 
individual  statements,   262 
Creditors, 

Relation  between  current  assets  and 
current  liabilities,  189;  Trade, 
185;  Of  a  business  enterprise, 
four  classes,  232-33;  Of  a  busi- 
ness enterprise,  economic  status 
of,  232-33 
Current  Assets, 

Value  and  interpretation  of,  139— 
163 ;  Advances  to  subsidiaries, 
94;  Cash  in  bank,  139;  Cash  on 
hand,  139;  Definition,  139;  Over- 
drafts, 140;  Stocks  and  bonds, 
141-44;  Notes  receivable,  147- 
49;  Kinds  of  accounts,  149-51; 
Bad  accounts,  149;  Doubtful  ac- 
counts, 149;  Good  accounts,  149; 
"Aging"  accounts,  150;  Treat- 
ment of  bad  accounts,  150-52; 
Inventory,  155;  Right  relation 
with  current  liabilities,  161—62, 
189;  Creditors,  189;  Bondhold- 
ers, 189 
See  Interest,  Investment 
Current  Liabilities,  See  Current  As- 
sets, Liabilities 
Customers,   Statements  of  new,   37-38 


Dawson,  S.  S.,  54 
Debt, 

Funded,       180;       Unfunded,       180; 
Bonded,   180-83;   Mortgage,   181- 
82 
Debts, 

Reserve  for  bad  and  doubtful,   153- 
54;  Bad,  and  auditor's  certificate, 
311;    Trade,    311-12 
Deferred  Assets, 

Meaning,    164-65;    Examples,    170- 
72 


324 


INDEX 


Deficit, 

Devices  to  avoid  showing,  81; 
Treatment   in    sub-companies,    253 

Delivery  Expense,  Distribution,   72-73 

Departmental  Statements, 
Value,    6;   Analytical,    19 

Depreciation, 

Land,  107;  Failure  to  provide  for, 
113;  General  problem,  113-14; 
Reserves,  114;  Equipment,  117; 
Element  of  cost,  197—98;  Impor- 
tance of  making  adequate  pro- 
vision for,  253;  Difficulty  of 
problem,    315 

Dickinson,  A.  L.,  On  profits,  130-31 

Directors,  Board  of,  Only  ones  to  dis- 
tribute profits,  dishonesty,  312- 
13 

Disbursements, 

Value  of  statement  of,  42 ;  Distin- 
guished  from   expenditures,    59 

Discounts, 

Trade,  on  sales,  50—51;  Cash  on 
purchase,  61—62;  Advantage  of 
cash,  62 ;  Quantity,  on  purchases, 
69;  Cash,  on  sales,  77-78;  On 
sale  of  capital  stock,  166;  Al- 
lowed on  bond  issues,  167-68; 
On   investments,   252—53 

Dividends, 

From  surplus,  75-76;  Out  of  capi- 
tal, 81,  93;  When  a  return  of 
capital  investment,  106;  Distri- 
bution, 212;  Closing  out  divi- 
dend-payable account,  212;  Char- 
acteristics, 212-13;  Declaration, 
214;  Illegal  types,  216;  Illegal, 
and  stockholders,  215;  Scrip, 
216;  Policies,  216-17;  Treat- 
ment of,  240-41 ;  Separate  sur- 
plus account,  241;  Unpaid  cumu- 
lative,   of    subsidiaries,    258 


Earning  Power,   Good-will  and,   123 

Earnings,    Gross,    See   Gross   Earnings 

Engineer,  Report  of, 

Allowance  for  error,  318 ;  Collabora- 
tion with  geologist,  318;  Knowl- 
edge of  costs  and  accounts,  318; 
Mining,  318;  Speculative  prob- 
lems, 318;  Value,  depends  on  ex- 
perience,   318 

England,     Dividends    on    Construction 
cost,    109 

Entries,  To  record  increase  due  to  eco- 
nomic causes,  206 

Equipment, 

Short  life,  111-12:  Stable  and  gar- 
age,    113;     Purchase    on    partial 


Equipment — continued 

payment,  116;  Depreciation,  117; 
Investment  should  be  segregated, 
118 

Equity,    In    surplus,    240 

Estimates,   Value   and  use   of,   274-75 

Expenditures,  Distinguished  from  dis- 
bursements, 59-60;  Revenue, 
and  surplus,  197 

Expense, 

Operating,  49;  Non-operating,  49; 
Distinguished  from  cost,  59  ;  Def- 
inition, 59;  Distribution  among 
departments,  60-61;  Borrowed 
funds,  non-operating,  62 ;  Organ- 
ization, 165—66 
See  Administrative  Expense.  Adver- 
tising Expense,  Delivery  Expense, 
Operating  Expense,  Selling  Ex- 
pense 

Expense  Accounts, 

Desirability  of  classification,  41; 
Sufficient  number  should  be  pro- 
vided,  41 

Expense  Schedules,   40-41 


"Factory  and  Office  Administration," 
14 

Federal  Income  Tax,  185 

Final  Statement,  274 

Financial   Statement, 

Interpretation,  3;  Classification,  4; 
Importance  to  executives,  6—7, 
10;  Purpose,  6;  Comparative,  7- 
8;  Requisites,  7;  Influence  of 
outside  factors  on,  9;  Importance 
to  stockholders,  10;  Pertinent 
facts  in,   89 

Fire  Loss,    Claims   aided   by   auditor's 
certificate,   306 

Fixed  Assets, 

Value  and  interpretation  of,  100— 
119;  Increase  in  value,  86,  205— 
06;  Definition,  100;  Land  dis- 
tinguished from  buildings,  100— 
01;  Real  estate,  100;  Surplus 
from  sale  of,  201-03,  207-08; 
Auditor's  certificate,  306—07; 
Valuation  in  appraiser's  report, 
317-18 
See  Buildings,  Equipment,  Furni- 
ture,  Land 

Fixtures, 

Capitalization,    112:    Valuation,    112 

Fraud,    Auditor    should    refuse    certifi- 
cate  in   case   of,    309—11 

Freight,   Outward,  method  of  treating, 
55 

Fuel,  How  charged,  63 


INDEX 


325 


Funds, 

Distinguished    from    reserves,    220- 
21;    Insurance,    224 
Furniture, 

Capitalization,    112;   Valuation,   112 


General  Summary,  45 

Geologist,      Should     collaborate     with 

mining    engineer,    318 
Good-will, 

Definition,  120-21;  Guthrie,  120- 
21;  Depends  on  reputation  and 
integrity,  121-22;  Value  of,  de- 
pendent on  location,  121;  Created 
by  monopolies,  120;  Public  serv- 
ice companies,  122-23;  Used  as  a 
subterfuge,  122 ;  Consolidated 
Gas  Company,  123;  Earning  pow- 
er, 123;  Method  of  valuing,  124- 
26;  Personality,  124;  Transfer- 
ability, 124;  Extraordinary  prof- 
its, 126;  Factors  to  be  eliminated 
in  valuing,  126-28;  Fictitious, 
128;  Mathematical  steps,  128; 
When  created,  129;  Dickinson, 
A.  L.,  130-31;  Is  it  a  fluctuating 
value?  130;  Bauer,  John,  131; 
Adjustment  in  consolidation,  132; 
In  consolidated  balance  sheet, 
133;  Valuation  of  patents,  trade- 
marks,  copyrights,    134—38 

Goods  Eeturned,  50-51 

Graphic  Representations, 

Use  of,  in  statements,  28-29;  Dis- 
advantages, 29 ;  Cautions  in  use 
of,  29-31;  Use  of  curves,  31-32; 
Cautions  in  preparing  line  charts, 
32-34 

Graphic   Statements,   28-29 

Gross  Earnings,   Indications  from,   74 

Gross  Income,   49-50 

Gross  Sales,  49-50 

Guthrie,   120-21 


Heat,  Light  and  Power  Account,  Dis- 
tribution of,   63-64 

Holding  Company, 

Assets,  84;  Purpose,  84-85;  Bal- 
ance sheet,  87;  Relation  to  sub- 
sidiary, 89;  Inadequate  state- 
ment, 91;  Dividends,  201;  State- 
ment of   subsidiary,    264—65 


Impairment  of  Capital,   80 
Income,   Primary,   48;    Secondary,   48; 
Percentages,     53 ;     Miscellaneous, 


Income — continued 

57;  Defined  from  each  stand- 
point, 60 ;  Borrowed  funds  a  de- 
duction from,  62;  Other,  76-77; 
Federal,  tax,  185;  Deferred  lia- 
bilities, 186-87;  Profit  and  loss 
statement,  and  balance  sheet, 
190-94;  Cost  and,  confused,  235- 
36 
Income    Charges, 

Insurance,   77;   Royalties,   77 
Income,   Gross,   See   Gross   Income 
Income,    Net,     Intrepretation,     75-76; 

See    Net    Income 
Income   Statement, 

General    divisions,    48-49;    Factors 
not  disclosed,   92 
Individual    Statements, 

Value,    to    managing    officials,    261- 
62;     Comparative,     and     compara- 
tive      consolidation       statements, 
262 
Inflation    of    Inventory    Values,    235, 

309 
Information, 
Statistical,    4 

See  Classified  Information 
Initial    Surplus,    Distribution   of,    208 
Instalment  Sales,  57-58 
Insurance, 

Included  in  income  charges,  77; 
Distribution,  78 ;  Adequate  to 
meet  loss,  224;  Corporations, 
224;  Appraisal,  cheap  form  of, 
316 
Insurance   Companies,    Investment   of, 

143 
Intangible    Assets,    Value    and    inter- 
pretation of,   120-139;    Good-will, 
120-21;   Guthrie,   120-21;   Valua- 
tion  of  patents,    trade-marks   and 
copyrights,    134-38 
See  Good-will 
Interest, 

On  borrowed  funds  included  in  in- 
come charges,  77;  On  construc- 
tion cost,  109;  On  notes  or  ac- 
counts receivable,  152;  Bond, 
169;  On  capital,  233-34;  Time 
element,  234;  On  borrowed  capi- 
tal in  auditor's  certificate,  314- 
15 
Inter-company,   The, 

Construction  work,    95 ;    Illustration 
of    transactions,    95;    Profit,    98; 
Surplus,    198-200 
Inventory, 

Purchase  records  and,  should  be 
available,  18-19;  Contents  of  rec- 
ord,   18-19;    Value    of    schedule, 


326 


INDEX 


Inventory — continued 

38-39;  Final,  compared  with 
sales,  57-58;  Inflated,  58,  82, 
235,  307;  Inter-company,  97-98, 
198-200;  Description,  155;  At 
cost  or  market  price,  156;  Trad- 
ing concern,  156;  Raw  material 
and  manufacturing  concern,  157; 
Possible  deductions  from  valua- 
tions, 159-61 ;  Valuation  in  au- 
ditor's certificate,  307-08;  Pro- 
cedure when  reliable,  308— 
09 

Investment, 

In  land,  102;  In  equipment,  should 
be  segregated,  110;  Machinery 
and  fixed  tools,  111-12;  Classi- 
fication of  permanent,  121—22; 
Stocks  and  bonds,  141-44;  Out- 
side companies,  142 ;  Stocks  of 
allied  companies,  142;  Bankers' 
and  Brokers',  143-44;  Insurance 
companies,  143 ;  Treatment  of 
stocks  and  bonds,  144;  Mining 
stocks,  146;  Timber  stocks,  147; 
Carrying  less  than  control,  239; 
Carrying  at  original  cost,  239; 
Periodic  revaluation,  239;  At 
cost,  objection  to,  241;  Revalua- 
tion complicated,  241-42;  Pre- 
miums, 250—52;  Discount  on,  252— 
53 ;  Viewpoint  concerning  state- 
ments,  262-63 

Investment     Companies,     Investments 
of,    143 


Labor, 

Definition,  62;  Items  included  in, 
62;  Cost  in  appraiser's  report, 
316-17 

Land, 

Holdings,  profits  from  sale  of,  57; 
Distinguished  from  buildings, 
100-01;  Improvement  cost,  101, 
103 ;  Held  as  an  investment, 
101;  Valuation  of  plant,  101;  In- 
vestment in,  102;  Treated  as 
stock  in  trade,  102-03;  Capital- 
ization of  improvements,  103; 
Valuation  of  leasehold  rights, 
104;  Mineral  and  timber,  105; 
Reserve  for  loss  in  value,  107; 
Depreciation  and  appreciation, 
107 

Law,  The 

And  the  accountant,  87;  At  vari- 
ance    with     accounting     practice, 


88 


Leasehold, 

Valuation  of  rights,  104;  Income 
from  an   annuity,    105 

Legislation,    and    Municipal    Budgets, 
292-93 

Liabilities, 

Service,  apportionment,  55—56;  De- 
fined and  classified,  179—80; 
American  practice,  179;  Ratio  of 
current  assets  to  current,  186; 
Deferred,  or  deferred  credit  to 
income,  186-87;  Kinds,  186-87; 
Contingent,  187-88;  Contingent, 
offset  by  contingent  assets,  187— 
88;  Contingent,  and  the  balance 
sheet,    188;    Conclusions,    188-94 

Logan,  James,  46-47 

Lump    Sum.     See    Budgets,    Municipal 


Machinery,  Investment  in,   111—12 

Maintenance,   Charges  for,   70 

Management,   Dishonest,   92 

Manipulation,   92 

Manufacturing   Concern,   Inventory   of 
raw   material,    157 

Margin,   Treatment  of,    145-46 

Mechanical  Devices,  Use  in  Preparing 
Statistics,     14 

Mining  Companies, 

Bonds,  105;  Sinking  fund,  105;  In- 
vestment in  stocks  of,  146 ;  En- 
gineer's   report,    318 

Minority    Interests, 

Oppressive  tactics  against,  242—48 ; 
Protection,  254;  Surplus,  consoli- 
dated   statements,    and,    254 

Monopolies,  Good-will  created  by,   122 

Mortgage, 

And  debt,  181-82;  Debts  and  bonds, 
183-84;  Chattel,  and  title,  183- 
84;    Real  estate,    183 

Municipal  Budgets,   See  Budgets,   Mu- 
nicipal 


Net  Income, 

Interpretation,  75-76;  Amount  re- 
quired by  bondholders,  75;  Re- 
lation to  capital  stock,  226—27; 
Ratio,  to  capital  stock,  228; 
Ratio,  to  total  invested  assets, 
229 

Net  Profits,   Transfer,   80 

Non-operating  Expenses,  49 

Notes, 

From  customers,  38;  Promissory, 
184 

Notes  Payable,  41,   184-85 


INDEX 


327 


Notes  Receivable, 

Schedule  of,  included  in  cash  report, 
41 ;  Classes,  147-49 ;  Interest, 
152 


Operating  Expense,  49,  74-75 
Orders    and    Sales,    Record   of,    17-18 
Organization,    Expenses,    165-66 
Other  Income,  Items  included  in,   76- 

77 
Outside  Factors,  Influence  in  Business 

Statements,  9 
Overdrafts,    140 
Overvaluation,  Of  assets,  on  auditor's 

certificate,   306 


Parent  Company,    83    et   seq.,    200-01 

Partial   Payment,    Equipment,    116 

Patents, 

Profits  from  sale  of,  57;  Valuation, 
134-35 

Percentage   Statement,   Value   of,    19- 
21 

Percentages, 

Cautions  in  use  of,  26—27;  Use  in 
comparative  statements,  26;  Cal- 
culation of,  in  income  account, 
53;  Must  be  on  correct  basis,  65— 
66;  Illustration  of  correct  basis, 
65-66 

Personal  Element,  Importance  of,   8-9 

Personality,    And    good-will,    124 

Preferred     Stock,     Unpaid     Dividends 
on   cumulative,    185 

Premium, 

On  bonds,  169;  On  investment, 
methods    of    carrying,    250—52 

Prepaid  Charges,  Credited  to  sales  ac- 
count, 52 

Price,    Selling,   as   basis   of  percentage 
of  profit,  53 

Primary  Income,  48 

Private  Budgets, 

Nature      and      function,      273-286; 

Means    of    guidance,    275 
See   Budgets,    Private 

Production, 

Relation  to  budgets,  279-80;  Re- 
ports,  39 

Professional  Reports, 

"Accounting  Practice  and  Audit- 
ing," 305;  Auditor's  certificate, 
305-06;  Interpretation,  305-09; 
Unjust  criticism,  305;  Proven 
facts  distinguished  from  specu- 
lative, 318-19;  Value,  318-19 
See  Auditor,  Certificate  of,  Engineer, 
Report  of,   etc. 


Profit  and  Loss, 

Statement,  4;  Departmental,  19; 
Credits  and  charges  to,  79-80 ; 
Income,    190-94 

Profits, 

Branch,  16;  Place  in  accounts,  57; 
Selling,  73-74;  Net,  73-74,  80; 
Corporation,  86,  130-31;  Dis- 
tributed only  by  directors,  86 ; 
Inter-company,  98 ;  Extraordi- 
nary, eliminated  in  valuing  good- 
will, 126;  Dickinson,  A.  L.,  130- 
31 ;  Inter-company,  inventory  and 
surplus,  198-200;  Fixed  assets 
revalued,  203-04;  Sinking  fund, 
219-20 

Promissory  Notes,  184 

"Properly  Drawn   Up,"    Explanation, 
311-12 

Property, 

Intangible,  concerning  value  of, 
204;  Accounts,  and  revaluation, 
204—05;  Report  on  mercantile, 
315-16 

Proprietorship, 

Reduction  partnerships,  81 ;  De- 
ferred credits  to  income,  187 

Prospectus,    See   Company   Reports 

Public  Service  Companies,   122-23 

Public    Utilities,     Appraisal     of    fixed 
property   necessary    for,    315 

Purchases, 

Finished  parts,  69 ;  Raw  materials, 
69;   Returned,   69-70 


Quick  Assets,  See  Assets 


Rate,    Difficulty   of    Selecting   Correct, 

234-35 
Ratio,    Use    of    in    statement,    27-28; 

Comparisons,   229 
Raw    Material, 

Purchases,  69;  Inventory,  157;  Cost, 

in   appraiser's  report,    316—17 
Real  Property,  See  Auditor,  Certificate 

of,    Fixed   Assets;    Land 
Rebates,  Allowed  to  customers,   71—72 
Receipts    and    Disbursements,     Value 

of  statement  of,   42 
Records, 

Orders,  17-18;  Purchase,  18;  Sales, 

18 
Renewals, 

Charges    for,    70;    Buildings,    110 
Rent,   Items   included   under,    77 
Repairs, 

Charges    for,    70;    Buildings,    110 
Replacement,    Of   buildings,    110 


328 


INDEX 


Reports,    Company,   See   Company   Re- 
ports,   Professional    Reports,    etc. 

Reserve, 

For  capitalization  charges  on 
carrying  land,  103-04;  Secret, 
113,  208-09,  209-11;  Deprecia- 
tion, 114;  For  bad  and  doubtful 
debts,  153-54;  That  is  not  part 
of  surplus,  198 ;  Created  out  of 
surplus,  2151;  Reserve  account 
misnamed,  215;  Distinguished 
from  funds,   220-21 

Results, 

Comparison,  22-25  ;  By  year,  22-23  ; 
By  months,  23;  By  week,  23-24; 
By    day,    24-25 

Revaluation, 

Profits  from  fixed  assets,  203—04; 
Appraisal  and,  204,  317;  Invest- 
ment, subject  to  complications, 
241-42 

Revenue,    Effect   of   charging  items   to 
capital,    76 

Royalties,  Included  in  income  charges, 
77 

Salaries,  And  wages  accrued,  185 

Sales, 

Analyses,  39-40;  Record  of,  17-18; 
Contents  of  sales  records,  49—50; 
Trade  discount  on,  50—51;  Sepa- 
rate acount  for  scrap  of  by-prod- 
uct, 52-53;  Instalment,  56; 
Comparison  with  amount  of  final 
inventory,  57—58;  Relation  of 
budgets  to,  278 

Sales  Account,   Credits   to,    49 

Sales,   Gross,   See  Gross   Sales 

Schedules, 

Accounts  receivable,  36-37;  In- 
ventory,   38-39;    Expense,    40-41 

Scrap,    Separate  account  for   sales   of, 
52-53 

Secondary  Income,  48 

Secret    Reserve,    113,    208-11 

Securities, 

Purchased  for  speculation,  145; 
Valuation,   147 

Selling    Expense,    Items    included    in, 
70,    72 

Sinking  Fund, 

Mining  company,  105;  Theory,  218- 
19;  Reserve,  a  charge  against 
profits,  219-20;  Proper,  221;  In- 
vestment of,  221-22 ;  Reserve 
fund  investments,  22—24 

Speculation,    Purchase    of    securities, 
145 

Statements, 

Income,     4;     Statistical,     4;     Profit 


Statements — continued 

and  loss,  4;  Departmental,  5-6; 
Analytical  expense,  19;  Depart- 
mental profit  and  loss,  19 ;  Analy- 
sis of  sales,  25—26;  Graphic,  28— 
29;  Of  new  customers,  37-38; 
False  impressions  from,  42—45 ; 
Dangers  of  inaccuracy  in,  42—43 ; 
Intentional  misrepresentation, 

43—44;  Incorrect  preparation  of, 
44—45 ;  Preparation  of,  for  exec- 
utives, 45—46 ;  Value  of  intelli- 
gent interpretation,  45—46;  Pos- 
sible legal  basis  for  consolidated, 
238-39 
See  Consolidated  Statements,  Fi- 
nancial Statements,  Statistical 
Statements 

Statistical   and   Graphical   Statements, 
13 

Statistical   Department,    Value    of,    40 

Statistical  Information,    4-5 

Statistical    Statement, 

Preparation,  4;  Place  of,  5;  Ob- 
jections   to,    20;    Form,    21-22 

Statistics,      Business,      See     Business 
Statistics 

Statistics,    Official,    14-15 

Stock, 

Common,  not  redeemable,  85; 
Treasury,  173—75;  Corporation 
and  treasury,  173—74 ;  Preferred, 
185;  Control  of,  when  not  com- 
plete,   258-60 

Stocks    and    Bonds,    Investments    in, 
141-44 

Stocks,  See  Investments 

Stockholders, 

Only  equitable  rights  in  assets,  85; 
Minority,  242-48,  254,  258;  Care- 
ful consideration  to  nature  of  au- 
ditor's   certificate,    313 

Stock    Ownership,    Not    ownership    of 
assets    implied,    85—86 

Subsidiary  Company, 

Corporations,  84;  Relation  to  hold- 
ing company,  89,  264—65 ;  Ad- 
vances to,  94;  Balance  sheet, 
95;  Operating  losses,  94;  Divi- 
dends, 200-01,  258;  Treatment 
of  deficit,   253 

Surplus, 

Payment  of  dividends  from,  75—76; 
Analysis  of  fluctuations  in,  81— 
82;  Definition,  195;  Kinds, 
195—96;  Relative  importance  of, 
and  assets,  196 ;  Resulting  from 
business  operations,  196 ;  Rev- 
enue expenditure,  197;  Reserves 
that    are    not    part    of,    198;    In- 


INDEX 


329 


Surplus — continued 

ter-company  profits  on  inventory, 
198-200;  Sale  of  fixed  assets, 
contributed  at  time  of  incorpora- 
tion, 207-08;  Initial,  distribution 
of,  208;  Disposition,  211;  Not 
necessarily  cash,  212;  Capital  ex- 
penditures charged  against,  214— 
15;  Equity  in,  240;  Account  of 
acquired  companies,  255 
See    Capitalized    Surplus 


Taxes, 

Items,      77;      Included     in     income 
charges,    77 
Timber    Companies, 

Valuation      difficult,      100;      Invest- 
ment,   147 
Trade    Creditors,    185 
Trade  Debts,  Auditor's  report,   311 
Trade  Discount  on   Sales,    50-51 
Trademarks,    Valuation,    134-36 
Trading  Concern,   Inventory,   156 
Transportation    Charges,    Element    of 

cost,   60 
Treasury  Stock, 

Definition,  173-75;  Creating,  by 
donation,  173-75;  Acquisition  of, 
176 


Turnover, 

Calculation,   66-67;   Rapid,   66-67 


Valuation, 

Buildings,  107-08;  Land,  107; 
Furniture  and  fixtures,  112; 
Stable  and  garage  equipment, 
113 ;  Patterns,  drawings  and 
dies,  113;  Good-will,  124  et  seq.; 
Patents,  trade-marks  and  copy- 
rights, 134-38;  Securities,  147; 
Inventory,  trading  concern,  156; 
Work  in  progress,  157-58;  Fin- 
ished goods,  158;  Merchandise 
pledged  as  collateral,  159;  of 
deferred  assets,  164;  Apprais- 
er's report,  316;  Cost  theory, 
317       • 

Verification  of  Trade  Debts  by  Audi- 
tor,   311-12 


Wages,   Salaries  and  accrued,  185 
Work  in  Progress,  Valuation  of,  157- 

58 
Working  Capital, 

Relation  to  total  assets,  230; 
Amount  needed  depends  upon 
nature    of    business,    230-31 


